Prosperity Bancshares Inc (PB) 2005 Q2 法說會逐字稿

Good day. Welcome to today's teleconference. Currently all sites are on line and in listen-only mode. Later you will have the opportunity to ask questions during our question-and-answer session. Without any further delay, I would like to turn your program over to Dan Rollins. Please go ahead sir.

Thank you. Good morning, ladies and gentlemen. Welcome to Prosperity Bancshares second quarter 2005 earnings call. This call is being broadcast live over the Internet at www.prosperitybanktx.com. And will be available for replay at the same location for the next few weeks. I'm Dan Rollins, Senior Vice President of Prosperity Bancshares, and here with me today is David Zalman, President and Chief Executive Officer; H.E. Tim Timanus Jr., Executive Vice President and Chief Operating Officer; and David Hallaway, our Chief Financial Officer.

This morning, David Zalman will lead off with a review of our financial results for the second quarter of 2005. He will be followed by David Hallaway who will spend a few minutes reviewing some of our financial statistics. Tim Timanus will discuss our lending activities, including asset quality, and I will provide an update on our progress with our recently completed acquisition, along with some detail on our loan and deposit mix.

Finally, we will open the call for questions. During the call, interested parties may participate live by following the instructions that will be provided by our call moderator, Adam. Or you may e-mail questions to investor.relations@prosperitybanktx.com.

I assume you have all received a copy of the earnings announcement we released earlier this morning. If not, please call Jennifer Nguyen at 713-693-9308 and she will be happy to fax a copy to you now.

Before we begin, let me make the usual disclaimers. Certain of the matters discussed in this presentation may constitute forward-looking statements for the purposes of the Federal Securities laws, and as such, may involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of Prosperity Bancshares to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements.

Additional information concerning factors that could cause actual results to be materially different than those in the forward-looking statements can be found in the Prosperity Bancshares filings with the Securities and Exchange Commission, including Forms 10-Q and 10-K and other reports and statements we have filed with the SEC. All forward-looking statements are expressly qualified in their entirety by these cautionary statements.

Now, let me turn the call over to David.

Thank you, Dan. We would like to welcome and thank everyone that is listening and participating in our second quarter conference call. Without question, the second quarter of 2005 was the most successful quarter in our history, with net income reaching $12.2 million or $0.44 per diluted common share. An increase in net income of 46% or 3.8 million, compared with the same period in the prior year. Our earnings of $0.44 per diluted share represents an increase of 12.8% over the $0.39 per diluted share we posted for the same period last year.

Our earnings growth continued the trends we have enjoyed in the past, despite a flattening yield curve. Our strong earnings growth was due to a stronger loan demand, and our strict adherence to cost controls.

We were proud of the recognition we received during the past quarter. We were named to the Sandler O'Neill 2005 Small Bank and Thrift All-Star list, and for the second year, we were honored to be included in the Keefe, Bruyette & Woods 2005 honor roll of high-performing banks.

We completed our acquisition of First Capital Bankers and its subsidiary FirstCapital Bank on March 1 of 2005. The operational integration started immediately. And for the most part, all of First Capital's operations have been combined into our systems. We are very proud to have the First Capital Bankers affiliated with us and look forward to a very successful future together.

With the combination of First Capital, we now have 85 full-service locations throughout Texas to better serve our customers. The combination significantly increases our presence in south Texas, from Kingsville, south of Corpus Christi, northward to Houston, and positions our Bank to play a much more important role in the development and growth in this part of our state.

Loans at June 30, 2005, were 1.52 billion, an increase of 729 million, or 92% compared with the 790 million at June 2004. Excluding the loans acquired as a part of the First Capital merger, linked quarter loan growth was 13% on an annualized basis. Excluding banking centers that were acquired within the past year, our two Austin acquisitions, as well as First Capital, internally-generated linked quarter loan growth was 21.3% on an annualized basis.

Obviously, this large increase in loans is a reflection of the mergers that have been completed in the past year. However, the internally-generated linked quarter growth of 21.3% highlights our strong commitment to increase our loan-to-deposit ratio internally.

As we have discussed in the past, we have not felt the need to chase high-cost deposits. This is reflected in a small decline in our total deposits for the quarter. We are focused on growing loan and deposit relationships that can provide us a fair return. With that in mind, we increased our non-interest bearing accounts over $15 million during the past quarter. While seeing a $30 million decline in certificates of deposits. We are confident the higher cost deposit run-off has subsided, and expect to see growth in deposits by year end. We continue to budget a 3 to 5% organic growth rate for deposits.

Despite the challenge of a flattening yield curve, our Board of Directors and our management team are very excited about the opportunities before us. We are located in one of the fastest growing states in our nation, and should benefit from the vibrant economy. In addition, we continue to see opportunities in the merger and acquisition market.

We continue to believe that our earnings guidance earlier this year toward the higher end of a range between $1.74 and $1.78 per diluted share for the full year of 2005 is accurate. Again, this is based on our belief that we will experience relatively stable are or moderately higher interest rates, and will not experience some tragic event around the world that may cause economic uncertainty.

Thanks again for your support of our Company. Let me turn over our discussion to David Hallaway, our CFO, to report some of the specific financial results we achieved this past quarter. David?

Thank you, David. A few -- just a few key points to highlight. First, net interest income increased 9.1 million or 47.2% year-over-year, and 4 million, or 16.4% linked quarter. And again, as we've said in the past, this is primarily due to an increase in our average earning assets, which was 36% year-over-year, and 14% linked quarter. It is a big driver in increasing our net interest income.

non-interest income increased 44.5% year-over-year and 20.6% link quarter. The interesting thing here on the non-interest income is that if we backed out the First Capital transaction on a linked quarter basis, our fee income grew 5.4%, and that was all across the board. It wasn't one specific thing. So very transparent in terms of growth there.

non-interest expense was up 47.6% year-over-year, and 12.5% link quarter, and again, this is due to the acquisition of First Capital this year. The efficiency ratio was 49% for the quarter, down from 51% the previous quarter. And this reduction -- this reduction reflects the execution of our projected costs saves from the recent acquisition. We continue to see some more opportunities going forward, and will continue to work on the plan that we've laid out.

The net interest margin on a tax equivalent basis was 3.82% for the quarter. Up from 3.57% second quarter of '04. A couple of things I would note here, one of the things that will benefit the margin and did benefit the margin, you note that the average loans as a percentage of earning assets this quarter was 50%. And that's compared to 35% second quarter last year, and 45% the first quarter of this year. So again, as the average loans increase as a percent of earning assets, that should have some positive benefit in the margin.

The other thing that I would note on here, as David mentioned earlier, the flattening yield curve does present some unique challenges to all financial institutions, us included, and looking at our model as of 6/30, one of the things that we see as we continue in this environment, that in terms of the net interest margin and where we see it going over the next 12 months, I would have to make the comment that we would see more of a modest increase versus the type of increases you've seen over the last few quarters. The last point that I would note is that the tangible ratio now stands at 5.21%.

And with that, I would like to turn over the presentation to Tim Timanus for some more detail on loans and asset quality.

Thank you, Dave. Nonperforming assets at quarter end June 30th, '05, totaled 2,738,000, or 0.18% of loans repossessed assets and other real estate. Compared to $3,447,000, or 0.23% at quarter end March 31st, '05. This represents a decrease of $709,000, or 21% in nonperforming assets from the quarter end March 31st, '05. The June 30th, '05 nonperforming asset total was comprised of $2,664,000 in loans, $49,000 in repossessed assets, and $25,000 in other real estate. Approximately 94% of these nonperforming assets pertain to loans in the portfolio banks acquired by Prosperity.

Net charge-offs for the three months ended June 30th, '05, were $115,000, compared to net recoveries of $106,000 for the three months ended March 31st, '05. The average monthly new loan production for the quarter ended June 30th, '05, was $58 million, compared to $47 million for the first quarter ended March 31st, '05 for a 23% increase. Loans outstanding at June 30th, '05, were 1 billion 520 million compared to 1 billion 500 million at March 31st, '05. The June 30th, '05 loan total is made up of 38% fixed rate loans, 43% adjusting as prime moves, and 19% resetting at specific intervals, such as quarterly or annually.

I will now turn it over to Dan Rollins.

Thank you, Tim. I want to spend just a few minutes reviewing the progress of our acquisition integration. As you know, during March, we completed our systems conversion of FirstCapital Bank, our largest acquisition to date. Since March, we have made good progress on our full integration plan. This was a large undertaking, and we continue to be pleased with the progress we are making. We have now completed the rebranding of all FirstCapital locations. From a cost save perspective, we believe that we are on target and on schedule to achieve the savings that we have projected.

I am proud to report that our team of bankers are competing effectively in all of our markets. We have a great team of customer-focused bankers in Texas and continue to look forward to great things in our markets. Our organic or same-store loan growth as we've discussed was 21.3% on an annualized basis for the second quarter. This was a great quarter for our loan team. We experienced growth in our commercial real estate portfolio, our agricultural portfolio, our home equity portfolio, and our construction loan portfolio.

At June 30th, 2005, our commercial industrial loans represented 15.7% of total loans, commercial -- excuse me, construction and land development loans represented 13.2% of the portfolio, and commercial real estate represented 36.5%, one to four family loans fell to 19.9%, and home equity loans now represent 3.4% of our total portfolio. Our loan pipeline remains strong and our team remains focused on producing results.

On the liability side of the balance sheet, I'm pleased to report that we are making progress towards our goal of rebalancing our deposit mix. We experienced approximately $15 million in non-interest bearing deposit growth. This was offset by the expected reduction of approximately $30 million in certificates of deposit. At quarter end, our deposits consisted of non-interest bearing DDA accounts, 21.3%, interest bearing checking accounts, 16.4, money market and savings accounts, 24.9%, and certificates of deposit declined to 37.2%.

Again, we are proud of team's performance and are looking forward to future opportunities. At this time, I'm ready to take questions.

[OPERATOR INSTRUCTIONS] We will take our first question from Brett Rabatin from FTN Midwest. Go ahead, please.

Hi, guys. Good morning.

Good morning, Brett.

Two questions for you. First off, I wondered if you could give us sort of a thought process on the gross balance sheet addition and subtraction going forward, kind of the amount that you think you will be adding on a quarterly basis, from a loan perspective, and then kind of what you're seeing on the other side, the prepayments or the cash flow and the securities basis, and how much more in deposits you might be seeing come off? And then secondly, just if you think M&A expectations or pricing, current pricing expectations are somewhat of an impediment to you guys doing some acquisitions here?

Let's -- can we take those backwards?

Sure.

We will do the easy one first. M&A activity, certainly I think there are some price expectations out there, but I think there is sure a lot of talk. Expectations can be one thing, but when it comes down to making the decision out there, there are a lot of people that want to talk. And we certainly have had a track record of being in that game and being willing to talk and find ways where we can find partners that want to partner up with us. I think that certainly price expectations are always something that we deal with, but I think there is opportunities for us on the M&A front.

On the deposit side, on the loan side, I guess the balance sheet side, Dave Hallaway can jump in here, when you look at the deposits, we continue to believe that we're going to grow deposits organically 3 to 5%, and we're looking for 10% loan growth. Now the security portfolio piece of that, Dave, I need to let you jump in and you kind of tell us where you want to be.

Just kind of reiterate on the deposit side, our expectation and looking at it in the first and second quarter, we haven't seen anything unusual from the deposit side. In fact, one of the things just looking at deposits through July, they are actually turned back up again and some of it probably seasonal as we wear through the year, so hopefully the deposits go up, that increases our earnings assets and if we continue to have good loan growth we'd soak up some that liquidity.

From a securities perspective, we continue to have the cash flow as we've laid out in the past, roughly 300 million a year. If the loan growth doesn't soak up that cash flow, we are going to have to reinvest it in the portfolio and that's what makes it interesting from kind of an interest rate environment, we need to see the long end of the curve kind of move up to 5 and 10 year, because if there is any excess cash flow coming out of the portfolio, we would certainly like to invest at the higher rates than when you saw about a month and a half ago when the ten year dropped for a brief time below 4%. So it's a lot of moving parts.

You want to add anything to that, David?

No, [inaudible].

Okay. And just one follow-up, where are you from a perspective, modeling things from here going forward, fed funds and 10-year potentially?

I think that the way I would answer, it and David can jump in, but I will answer it first. One of the things in looking at our model at 6/30, it looks, and I probably should add, when we modeled this out, we are not modeling it with 10% loan growth or 20% loan growth, we're just taking the balance sheet at that point in time and projecting it forward. But it looks like we have moved into more of a neutral position at this point. So when we're looking at our margin going forward, that's why I said I think it is more of a modest increase over the 12 months and not the significant jumps you've been seeing over the last few quarters.

We've seen some big movement in margin over the last year.

Over the last year it is tremendous.

Right.

Okay. Great. Thanks, guys.

Thank you. We will take our next question from Campbell Chaney from Sanders Morris Harris. Go ahead, please.

Good morning, everyone.

Good morning.

David, was there any acceleration of premium amortization in the securities portfolio, anything meaningful during the quarter?

I didn't see any. David, you want to comment on it? No, we didn't see anything.

Okay. Great. And then the terrific traction you got in some of your DDA accounts and some of your loans, was there any change in management strategies now that FirstCapital is on board just to kind of kick start the process?

I will jump in real quickly. I think it is just the normal process we go through as we bring on new partners, and it just takes a little time, because if you go back and look at the partners we bring on, normally their CD percentage of total deposits is a lot higher than Prosperity Bank overall, and as you see us working through it, we're trying to get customer relationships versus just a CD relationship. So in conjunction with this transaction specifically, I don't think we're doing anything differently, it is just as we're following the plan, this is what we should be seeing.

I would agree with that. Campbell, I don't think this is -- this is Dan. I don't think we really changed any management philosophy or we've not started any initiatives that would drive some of that. I think it just -- I've used many analogies before, when you come through these conversions and these changes, change can be disruptive, people sometimes -- everybody deals with change a little different and it just takes time to let the waters calm back down again. We sailed into rough seas and we've got to sail out and get into some smooth water and I think that's where we're headed right now.

Would it be fair to say that the momentum is still building?

Absolutely. I think that's a fair statement.

And then one other question, on the other, other income item that was at 1.3 million for the quarter. Can you give us some color on what is included in that? If it is anything different than say prior quarters?

That's a good point. There is some different things in there, and it is specifically related to First Capital and some of the things they were doing. One of the -- a couple of numbers that are in there and as they get bigger we're going to have to break them out, one of the things that came with the First Capital transactions, they had some bulling [ph] some banking life insurance, that number on a monthly basis was about 35,000 a month, so you can calculate that. That is in there. There was a leased asset program that First Capital had that is probably throwing off roughly $90,000 a month, so that times three, you can see that is probably a big number that is in there, also.

And you think those will continue?

They will absolutely continue. On the life insurance, you can't really unwind it. There is a lot of tax implications. So that is something that will stay on our balance sheet as well as the leased asset.

Okay, terrific. And then I think one last comment was the -- I forgot who said it, was talking about deposit competition was starting to ebb a little bit. Can you give us some color on why you think the deposit competition is starting to slow down a little? I guess rate competition is what you're talking about.

I don't think that's what we were saying. And I don't know if that was me or David saying it, I think what we were saying was that we think that the outflow on the CD side has subsided on our side of the balance sheet, as we look at what CDs are in the queue to mature or renew going forward. From a rate perspective, I don't want to speak for everybody here, but I don't think the competition has gone away. I think it is still there, as it has always been.

Okay. Well, I appreciate the clarification. That's what I was looking for. Great, thanks, good quarter.

Thank you. We will take our next question from Barry McCarver from Stephens, Inc. Go ahead, please.

Good morning, guys. Great quarter.

Good morning.

First off, could you give us just a little update on, I guess, loan pricing, loan competitions specifically, kind of in your sweet spot of the small business loans versus moving up stream a little bit to the bigger sized loans?

Yes, the loan growth that we saw this quarter was not really in any big huge loans that are going to be LIBOR priced, because as we said before, we don't have a lot of that on the balance sheet, and actually, under prime loans shrank or went down for the quarter for us. But I think from a pricing perspective, just like on the deposit side, pricing competition can get pretty steep out there. Tim and David, you guys both sit in the committee every week.

I think that is exactly right. What we saw for the quarter really is no different than what we've been seeing for several months. We have to stay focused on the kind of customer that works for us. And we think that our folks that are out there in the field are doing just that.

Okay. Fair enough. Dan, can you give us -- one more time, run through your goals on the integration expense and give us an idea of what costs might be coming out in the third and fourth quarter?

Sure. When we came forward, we said we wanted to cut 27.5% of First Capital's expense base, and I don't have a number to tell you where, 70% or 73% or whatever the number is of where we are today, but we're well down the path of hitting those targets. On a go-forward basis, all of the major components are in place today. The remaining pieces of the puzzle continue to be just tinkering with the little things, every little bit adds up in our world, we are pretty cost conscious. And so, we continue to watch and every little thing that we're doing from how we're moving reports, or checks through the system on a courier basis, to how we're moving loan docs through the system, to all the things that we can look at to what our communication cost is, all of those things play into something that we continue to look at. And right now, we're four or five months into this, Dave is sitting here looking at me, Dave looks at every invoice that comes through, and we question, what is this, how do we benefit from it? Is it something that is driving dollars to the bottom line? And that takes time to get all of that stuff to flush through the process. Dave?

Yes, I mean I would agree with what Dan is saying, I think the question is -- what you're getting to is are we going to be able to drive down our expenses going forward compared to looking at the second quarter? And I think there is opportunity to do that. I don't know that I have a specific number for you, but I do think that we will be able to drive that down, and I wouldn't anticipate any -- hopefully no increases in our operating expenses going forward. Other than the normal type stuff.

Okay. Fair enough. And then I guess just two quick things, just comment on the reserve ratio, it continues to trickle down, we expect this kind of run rate in terms of an allowance. And then secondly, Dave, can you give us the margin in the last month of the quarter, what that was?

Surprising enough on the margin, it is interesting, that is kind of playing into our model, so it hopefully gives us some confidence in that model, but it was interesting because the 3.82, the last month, that was what it was in the last month, it was pretty consistent over the three months actually.

Okay.

On the loan loss reserve, Barry, I think you have to go back and look at kind of how we got to where we are, the comparison year over year shows a pretty big decline. I think you readily understand that the big piece of that has to do with the change in the accounting rules surrounding the merger and the acquisition that we just did with First Capital and how we are allowed and are now required to account for the combination of their loan loss reserve with ours. So that certainly is what moved us from the 1.30-something to the 1.13 last quarter, and we did move from 1.13 to 1.11 this quarter. I think as we look at where we are in today's regulatory and accounting environment, they're looking at justification for what is going in there, we saw a total of $115,000 in net charge-offs, we provisioned 120 for the quarter, on a year-to-date basis, we provisioned 240, against net charge-offs of less than $10,000. So certainly from a provision versus the loss ratio, we are above that.

But the portfolio is growing, which is what is driving that number down. I think all of us believe that we need to be cognizant of where that provision and loan loss reserve is in light of all the accounting rules and your question, direct question is is do we expect to see it trickle down further? And I don't know that we would say that we would want to see it trickle down a whole lot, but I don't see it moving a whole lot up, either.

Dan, I might add to that, if you go back and look at calendar year '04, we had total charge-offs of approximately $950,000, and recoveries about $465,000. So the net charge-off was a little over $480,000. And we provisioned for that during that during the course of the year. So the status quo was to maintained in an appropriate manner, the whole calendar year.

Does that help you, Barry?

Yes, that's great. Thanks a lot, guys.

Thank you.

We will take our next question from Christopher Marinac from Fig Partners. Go ahead, please.

Good morning, fellows.

Good morning.

This is actually Brett Malone, Chris couldn't be on the call. He had to be on another one. I wanted to ask you in regard to something you said in an earlier question, you spoke about the reduction in CD percentage, based on basically the acquisition, and the -- what was coming in from First Capital. And just looking at your branch map now, I recognized some of the -- a majority of branches are, let's say, not metropolitan, but more rural and I've heard from some bankers that CD percentages sometimes are difficult because it is just what the customer is requiring. And I wanted to see what your feeling was on that, and whether or not you've heard anything from management at First Capital about that?

Sure. The First Capital management team is here, and we're certainly not wanting to run off good customers. I think when you look at what -- I think David said it in his talk, we're looking for relationships with customers that are beneficial to the customer and beneficial to us on the deposit and loan side. And you're right, in many of the rural markets, those customers are CD deposit customers. I would want to make sure that we're clear again, we don't have any brokered CDs or what we would consider to be hot money in the CD class. The CDs that we have in the bank today by and large across the entire system are our customers, Mr. and Mrs. Jones and Mr. and Mrs. Smith that want to put their money into our Bank, and in the rural markets, that can be a larger percentage of deposits.

I think I also want to make sure we're all clear, while we do have 85 locations, a little less than half of those would be classified as rural markets. We have 33 locations in the Houston area. In Dallas metropolitan proper, we're sitting at 8. We've got 7 in the Austin metropolitan area. And 10 or 12 in the Corpus Christi metropolitan area. So the majority of the locations are larger markets, our MSA markets in the state of Texas, but your analogy I think is correct, the rural markets are the smaller town markets, do see a larger proportion of CDs and we're not trying to run those people off by any stretch of the imagination.

I guess just to follow up on that, it would be -- have you seen anything in competition from these locations?

In competition, you're talking about the competition in those markets?

Specifically in maybe maturity of CDs, whether or not there has been a shift, or costs have increased across the board, or maybe just specific maturities? Maybe longer versus shorter?

Oh, are customers going longer?

Yes.

Or are our competitors driving -- ?

In other words, what your customer response is.

What does the customer want?

Versus your competitors.

I don't know that I can answer that question with any factual information to date because I don't know we track that in any way. Dave, are you aware of that? We certainly -- we are offering a product mix today that offers short and long-term CDs. We think that we are competitive across the entire range of spectrum there. And in some markets, maybe people think they need to go longer and other markets they may be going shorter.

What about our competitors? Have we seen anything in our competitors doing something long, short?

I think what I see, the majority of the pressure there comes from the competition is in the one-year and beyond maturity. The -- really a year and a half, two years, and up to four years.

And, Tim, I would say being in the field a lot, I have seen customers starting to extend into the five-year product where I've not seen them in the past. Customers are willing to maybe go one year out, but as you start seeing these 4% interest rates and some banks have seen even offers as much as 4.85, and I've seen people starting to go toward those longer, to the five-year product.

I agree. I think there is a little bit more of a migration in that direction.

From a factual standpoint I don't have what that would be in our Company, but I have seen people that leave to go for the higher rates want to extend further out.

Does that answer your question?

Yes. Thank you, gentlemen.

Thank you.

Thank you. We will take our next question from Scott Alaniz from Sandler, O'Neill. Please go ahead.

Sounds like deposits are the topic of the day, so I should ask about that. Dan, to get 3 to 5% deposit growth this year, what do you think you will have to do pricing-wise on deposits? Meaning, will you have to adjust Prosperity's relative position within its markets to get 3 to 5%? Or do you think you can get it just through your normal efforts?

I think that is a good question. I think certainly we watch rates every day, and every week. I don't think we're that far out of the market on our rates today, Scott. So I think what you're seeing in the deposits that are moving around today, and the re-mixing of the balance sheet that's there, as David said, I think briefly when you look at July, the deposits are up fairly significantly, so far, into July, and that's not coming on the CD side, that is coming on the free money low rate checking money. So I don't know that we need to make any significant change in our model or in our pricing structure. I think we need to continue to tweak the process, and again, coming through the largest acquisition we've ever done, as much as everybody wants to make shows things invisible, that creates noise all the way around.

We -- Scott, can I take a shot at that?

Yes, please.

Basically, the answer is direct, no, we don't have to change our pricing model. I think what you're seeing here is something that happens. We do a lot of mergers and acquisitions, and this is something that has happened through most of our mergers and acquisitions, but usually they're covered up with our internal growth, but whenever you take a larger institution the size of First Capital that's $700 million or $ 800 million in size, it is hard to make up all of that growth in one quarter.

So from what we see right now and even the increase in deposits that we see already this month, $30 or $40 million in July, I think that -- I don't think that we will have to change it. I think that just through our normal course of action, again, as David mentioned earlier, the mix of money changes, we generally -- the other banks that join us have generally have a higher ratio of CDs compared to transaction accounts, and this is just the evolution that that will trickle down, and our transaction accounts will pick up through internal growth. And I still think that we are going to stay on the 3 to 5% internal growth rate.

You got to keep in mind, First Capital was a thrift charter that had -- and quite frankly, they had done a fantastic job of moving from a thrift to a more commercial bank-like balance sheet, but they still have a lot of customer who are thrift-based or thrift-type customers, and while we don't want to run those off, we need to continue to augment that with true banking customers.

And a little more detailed question relating to the cost of interest-bearing transaction accounts, just looking at your average -- sheet in the press release on average yield, the average yield on interest-bearing transaction accounts was 95 basis points, which is down from 102 basis points in March. Is there -- was that just a mix shift adjustment with First Capital coming in there that affected that or was there something else?

That's right. That's exactly right. When you look at what is in there, there are multiple different product types in there that as money moves from one product type to another, or moves out of a higher yielding demand account, into a money market account, or into a certificate of deposit, when you look at the numbers, I think I gave you the percentages, money market balances actually went up, and interest bearing demand went down a little bit during the quarter. And almost the same amount, almost the same amount, a little less on one than the other, but that is all that is is just money movement.

Okay. And then for David Zalman, one of the things that was mentioned earlier was I believe you all are targeting 10 or so percent loan growth, which is let's say from here, about $150 million, but that the securities portfolio will return to you some $300 million, which just looking at that would suggest that you are going to have to reinvest that money somewhere. And I would like to get David Zalman, your thoughts, kind of on the securities portfolio and what your plans are for the rest of the year.

Well, again, that's what, I guess, when we talk about a flattening yield curve and being a challenging environment for us, and for all banks, that you probably hit the nail on the head, that's the challenge. The other $150 million, if the yield curve really became a yield curve --

It became a curve, it became a curve?

It helps us. As it stays flat right now, that's the one that puts the challenge and the pressure on us, but what we're looking at right now, there is not a lot of difference buying a two-year, one-time callable agency at 420 and buying say a 10-year mortgage-backed fully amortized that has a 3-year average life, so those are kind of the products that we're looking at right now. We're trying to keep the portfolio at a 3-year average life and a 2-point-something-year duration.

And sometimes people that we buy bonds from, not Sandler O'Neill, of course, but other companies, are critical because we have not extended our portfolio out more, and picked up some yield. But again, we still don't think that is the thing to do. We've designed the portfolio that will never hit homeruns one way or another, but we will keep on getting singles and doubles and the portfolio over a period of time, even in the market like it is today, with nothing changing, and 18 months from now, we should see some significant price yield pickup just because we have that money rolling off.

It doesn't happen overnight where some of the other -- our competitors, their rates change daily, ours don't, it takes 12 to 18 months before we start seeing significant impact. But that has been our strategy, that is our technique and I would say I continue to seeing us going in that same direction -- doing the same thing we have always done.

Terrific. Thank you.

Thank you, Scott.

We will take our next question from Jennifer Demba from SunTrust Robinson Humphrey. Please go ahead.

Good morning. Nice quarter. Can you give us some indication on where the internal loan growth came from geographically? And by category? And I noticed you -- wondering how many employees you anticipate having at the end of September and at the end of the year?

Okay. Let's see. Let me tell you what I said already. Let me kind of go back through on the loan piece of that, Jennifer. This is Dan, how are you?

Great.

I did not, but let me kind of see if I can kind of talk some of that. On the portfolio mix, we saw growth in commercial real estate, we saw growth in ag, and we saw growth in construction, and also our home equity portfolio increased. So, when you kind of walk through that, certainly the one to four families declined as a percent of our total portfolio, and then I can walk through those percentages again if that would help you on where the portfolio ended up at the end of the quarter. Do you want those numbers again?

No, that's okay.

Okay. From a traffic standpoint, we certainly track that, we're seeing good loan growth across the system, Austin, it was broken out in the press release, you can see they had some runoff in loans, I think they had a large customer that decided that rates had gone against them and they had liquidity and they were going to pay that off and that was a significant move for them. Certainly the best loan growth that we're seeing is in south Texas and in the Houston markets, but we have more people on the ground there.

Okay. And what about on the employee count, what are you anticipating at the end of the third quarter and near the end of the fourth quarter?

Headcount.

Jennifer, you always want to be so factual. But we feel right now that we're probably about -- you can jump in, Dave, if I'm wrong on this about 25 people more than what we would like to be. Again, as we said in the past, we're not going to just go out and let people go. Basically, the attrition over the next three to six months with us having 800 or 900 people, just simple attrition should take care of that and we are just not going to rehire, but we feel like we're still at least 25 people too high.

We watch headcount across every department in every banking center on a regular basis. A part of hiring people or replacing people, we go through a process to kind of analyze the need and the necessity of that and I think we will just see that fall.

We have a good system too, I mean, before anybody, before any banking center or any department can hire a person or an individual they have to get an approval from a Tim Timanus and Dan Rollins. So they can't just arbitrarily go and hire somebody without getting approval, and that's the way we can control the attrition.

One more question. Could you comment on the direction that you saw in service charges on an internal basis?

Yes, I mean, what is interesting, I think the big discussion in the first quarter was, I guess everybody was reporting that fee income fell off. And my only response, and I can only talk about our Bank, historically, as we said before, fee income tends to spike in the fourth quarter, because I guess it is the holiday, the best that we can determine, and then always falls off in the first quarter. And then it picks back up again as we wear through the year. And looking through the number, and combing through them, that's what we have seen. We see it drop off first quarter, and then rebound back here in the second quarter.

Our strongest quarter is definitely the fourth quarter. I mean, we're really blown out in the fourth quarter, usually.

That's right.

Thank you very much.

Thanks, Jennifer.

We will take our next question from Brent Christ from Fox-Pitt. Please go ahead.

Good morning, guys.

Good morning, Brent.

You guys obviously had some very strong internal loan generation this quarter. But the run-offs masking some of the lift. I kind of wanted to get a sense for what your expectation is in terms of where you stand, in terms of the run-off both from First Capital or the Austin deals.

Gosh, I think, Tim, you want to jump in on that?

I think number one, we've seen the majority of the run-off in terms of rates obviously having gone down in the past, so we don't anticipate a whole lot of that going forward. Our portfolio on the loan side is fairly liquid in that it tends to roll over between two and three years historically, probably closer to three years than two. So that's a normal thing for us. I don't think we see anything unusual on the horizon in terms of loan run-off. I think it is business as usual going forward from that standpoint.

Our loan producers are focused on customer retention. And if we see a good piece of business headed the direction of leaving us, we always focus on it. Sometimes we make the decision to do what is necessary to preserve it and sometimes it is not in our best interest to do that and we let it go. But it is a constant focus that we have. So I really don't see anything unusual or anything changing in that regard.

Okay.

Brent, this is Dan. I think when you so as many acquisitions as we do, as I said a minute ago, part of the puzzle is, with 100 and some-on-odd lenders on the ground in different market, some of them have been on the ground in different markets, some of them have been on the ground for a long time with our Company, others have hired in recently, and others have been a part of a merger and acquisition in the last year or two. Everybody deals with that change on a different timetable, and some folks can hit the ground running on day one and be productive and do well, others it takes a little more time, and certainly that can cause some customer disruption. I think when you look at what is happening on the First Capital loans today, there are some folks out there that are trying to take advantage of where we are, and quite frankly, we do the same thing on the other side when we get an opportunity.

At the same time, Dan, there are certain loans that we do -- would like to outsource at the same time. So I would be more specific and say, there is probably $10 million or $15 million in credits that we would like to see placed with us.

It would be okay with us if they left.

It would be okay, 15 million outsourced and I would tell you that we are working toward that with some of these credits. At the same time, as Dan mentioned, these lenders that once they join the First Capital group, I -- the answer that Austin as I think it is through over there, I think it is subsiding, I think they're on the upturn. First Capital really did -- they're so new, it is almost like a shock when you come into another company, learning how to do the analysis and how to present it to the loan committee that the first three months they don't get a lot of production, so I think they will start getting kicked in now and we should start seeing some pretty good production from them as to where they were dormant in the past, I think they should start upticking once they get through what the specific loans that we still would like to outsource.

Okay. And then on the service charges, aside from the seasonal lift, was there any specific initiatives that you guys had that led to the pickup this quarter or was it just purely a --?

There were two pieces of that change, Brett. Certainly the full quarter of First Capital was the largest piece of that, and then just organic fee growth, there was a little bit of that. But there was no special product, there was no special program, there was no smoke and mirrors here, I mean this was just pure plain Jane old-fashioned banking.

Thanks a lot, guys.

We will take our next question from Charlie Ernst with Sandler O'Neill. Please go ahead.

Hi, guys.

Good morning.

I just wanted to get a little bit of color about these transactions and kind of what margins came on with the deals, and if you could add any color as to how much of an impact they're having on the margins over the last quarter or two.

What deals? Could you be more specific for me, Charlie?

The ones that you all recently closed.

Talking about loans?

No, just the -- you're adding the balance sheets to your balance sheet --

You're talking about the mergers or the acquisitions of the First Capital and the Austin bank?

Exactly.

Okay. Now let's back up again so I hear the question. What types of customer base?

No, just the margins that mathematically are being added.

I mean those, the First Capital, if you went back and looked at their call report, you would see that their margin is pretty similar to ours prior to the overall -- prior to us consolidating. The one thing you would have to note on their margin, they had some trust preferred issuance, they were not adding that interest expense into their margin when they calculated. It is a private company. They didn't do that. So coming forward, when you factor it all in, surprisingly enough, the margins were pretty similar. What they brought to the table is obviously a higher loan deposit ratio.

And a larger portion of floating rate loans.

Floating rate loans, yes. So what they bring to the table going forward, as rates go up, that helps us, because of the variable loans. It was the same issue with the two Austin banks, actually, too. They were -- combined total, the loan deposit ratio for both those banks was roughly, I want to say about 80%, 78% so it was the same theory. So you could probably -- I guess one of the things you could say is it really helps us to add those three banks because of their loan deposit ratio and the variable loans they brought to the books. From a margin perspective, I don't know they helped that much because, again, being private companies, they were probably a little more aggressive in the things that they did on their balance sheet.

Wouldn't you say though, Dave, or you could make an analogy that the margin might not have been improved that much so far, but if interest rates in fact do go up and with them having floating rates they would help our margin going forward?

Going forward, yes. And that comes back, Tim gave some numbers, Charlie, on the portfolio and where we were from a floating rate or a variable rate perspective, and I think for the last couple of quarters now, we've seen the floating rate portion of the portfolio continue to increase. That is a number that isn't going to move up in big spurts, but we've moved up 2 or 3% over the last couple of quarters and what we're carrying today and floating rate loans versus what we were in the past.

And did you change the mix of the balance sheets before you put them onto your balance sheet? I mean it just looks like the bond portfolio is not up a whole lot. So I'm just trying to get a sense as to whether this margin improvement, whether you consider it to be cool or whether it's kind of mathematically driven a little bit?

I'm not sure I understand the question there, either. We've not done anything through an acquisition that would change, we've taken the banks and we've merged them in with us.

I think you see that percentage of the security portfolio gone down just simply because of the loan growth that we're putting on. It's starting to -- First Capital, again, remember they were -- what were they 80% loan deposit, it has a huge effect in changing the mix of money, and of course, we're having good internal growth on top of that. That's why you're seeing that security portfolio starting to reduce a little bit.

And their yield, too, Dave, their yield was actually lower than our yield was --

On the securities portfolio.

On the securities portfolio. On the other hand, again, the majority of their portfolio was made up of our products, adjustable rate mortgage products, so again, where they don't change immediately as rate goes up, if -- over a year period of time, you would see a good pop if rates do go up, because those yields will adjust.

Okay, and lastly, Dan, it sounded like are most of the cost savings are in the numbers now? Is that a fair statement? I mean there is some incremental additions but --

Certainly the majority of the cost saves are in there the numbers now.

Okay. Great. Thanks a lot, guys. Nice quarter.

Thank you.

[OPERATOR INSTRUCTIONS] We will take our next question from Joe Stieven from Stifel Nicolaus. Please go ahead.

Good morning, guys. Actually my question was really to drill down on the internal loan growth and that was done two questions ago, so I am really done. And very good quarter, guys. Thank you.

Thanks.

It appears we have no further questions, gentlemen. At this time I will turn it back to you for any closing remarks.

Thank you very much, Adam. Certainly want to thank everybody for participating with us. We appreciate everybody's support. We're proud of what we've been able to accomplish so far and we look forward to continuing to improve going forward. Thank you all very much.