Heritage Financial Corporation (HFWA) Q2 2012 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the Heritage Financial Second Quarter Earnings Release. [Operator Instructions] As a reminder, today’s call is being recorded. With that being said, I’ll turn the conference now to the President and CEO, Mr. Brian Vance. Please go ahead sir.

Thanks, John. I appreciate it. I’d like to welcome all that have called in and of course those who also maybe listening later in our recorded version. Attending with me here this morning is Don Hinson, our Chief Financial Officer. Our earnings press release went out yesterday afternoon. Hopefully, you had an opportunity to review the release prior to the call. And as I always do, I’ll read a forward-looking statements very quickly for the record. Statements concerning future performances, developments or events, expectations for growth and market forecasts and other guidance on future periods constitute forward-looking statements. Forward-looking statements are subject to a number of risks and uncertainties that might cause actual results to differ materially from stated expectations. Specific factors include, but are not limited to the effective interest rate changes; risks associated with the acquisition of other banks, and opening new branches; the ability to control cost and expenses; credit risks of lending activities, including changes to level and trend of loan delinquencies and write-offs; changes in general economic conditions, either nationally or in our market areas. These factors could affect the company’s financial results. You should not place undue reliance on any forward-looking statements and we undertake no obligation to update any such statements. The company does not undertake or specifically disclaim any obligation to revise potentially forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. Additional information on these and other factors are included in the company’s filings with the Securities and Exchange Commission. I will go through those some highlights of our second quarter. Diluted earnings per share was $0.21 for the quarter ending June 30 compared to $0.27 per share for the quarter ended March 31, and 11% -- $0.11 in the prior year quarter ended June 30, 2011. Non-performing originated loans decreased to 1.69% of the total originated loans for June 30, from 1.88% at March 31, 2012, and from 2.57% at June 30, 2011. Originated loan receivables increased $16.3 million during the quarter ended June 30 and common stock repurchases totaled approximately 383 shares for the quarter ended June 30, 2012. We posted Q2 net income of $3.19 million or $0.21 per share, which is an increase from Q2, 2011 earnings of $1.69 million or $0.11 per share, and a decrease from Q1, 2012 net income of $4.17 million or $0.27 per share. Our total loan loss provision for Q2 was $618,000, $200,000 for the originated loans and $418,000 for the purchase loans, compared to a Q1 negative provision of $109,000, 0 for originated loans and negative $109,000 for purchase loans. Net charge-offs on originated loans for Q2 were $1.9 million compared to net recoveries of $246,000 in Q1, 2012. Our originated loan loss allowance to originated loans decreased to 2.44% at June 30 from 2.69% at March 31, 2012. However, our coverage ratio still stayed relatively the same at 145%, compared to 143% at March 31. Overall, I believe this is a solid earnings quarter with nice improvements in our credit metrics and loan growth. Don Hinson will take a few moments and cover our balance sheet and income statements, as income statement changes as well as a few comments about our acquisition accounting. Don?

Thanks, Brian. I’ll start first with the balance sheet. Total assets decreased slightly from the prior quarter end and we are at $1.34 billion at June 30. Net loans increased $11.5 million during the quarter, due mostly to an increase in originated commercial loans. Net originated loans increased $18 million during the quarter. Total deposits decreased $26.2 million during Q2. Quarter-over-quarter, non-maturity deposits decreased $18.8 million, while CDs decreased $7.4 million. We experienced a higher than usual seasonal decrease in deposits during the second quarter of this year. Our non-maturity deposit ratio continued to be very strong 72.4% of total deposits and our percentage of non-interest demand deposits -- total deposits also remained strong at 20.5%. Total equity decreased $5.5 million during Q2. The ratio of the tangible common equity to tangible assets decreased slightly to 14.0% at June 30 from 14.1% at March 31. Our tangible book value per common share decreased to $12.27 at June 30, from $12.36 at March 31. The decrease in these metrics was driven by a combination of cash dividend in the amount of $4.3 million and stock buybacks in the amount of $5.2 million partially offset by the $3.2 million in net income for the quarter. During Q2 2012, 383,000 shares of stock repurchased an average price of $13.27. Since the inception of the current buyback plan, we have repurchased 591 shares at an average price of $12.83. Looking at the acquired loans, during the quarter, we recorded the provision for loan losses on the acquired loans in the amount of 419,000. This increased provision from prior quarter would be substantially to decrease an estimated cash flow in credit pools of the acquired loans in previous cash flow estimations. The change in FDIC indemnification asset was a negative 19,000 in Q2, 2012 compared to a negative 176,000 in Q1 2012. As a reminder, the FDIC indemnification asset relates to the covered loans obtained in the Cowlitz acquisition. Our net interest margin was for Q2 was 5.25%. This is a 10 basis points decrease from 5.35% in Q1 2012 and 68 basis points decrease from 5.93% in Q2 2011. The decrease in margin from the prior quarter reduced substantially through re-pricing of existing loan portfolio as well as new loans being booked at lower rate. Partially offsetting the decline in loan yield is a decline in our cost of funds. Our cost of funds for Q2 decreased to 42 basis points compared to 45 basis points in Q1. The effect on the net interest margin of incremental discount accretion overstated note rates on the acquired loan portfolios for Q2 was approximately 55 basis points. This compares the 49 basis points in Q1. Without the effect of incremental discount accretion, the net interest margin was 4.70% in Q2, compared to 4.86% in Q1. Due to low rate environment, which we see assets re-pricing at a faster rate in the positive expect margins to continue to decline trend. Non-interest income was $2.1 million for Q2 2012. This is a slight improvement over Q1 due mostly to the change in FDIC indemnification asset. Non-interest expense increased $272,000 to $12.9 million for the quarter ended June 30 compared to $12.6 million for Q1 2012. The increase was due to a combination of various expense items including salaries and benefits and professional services. For Q2, 2012, our efficiency ratio was 70.4% compared to 67.7% in Q1 due to the continuing growth related expenses in contract interest margins. We are experiencing higher than historical efficiency ratios. We expect this trend to continue in the short-term. Brian will now have an update on the overall loan growth and loan quality changes as well as some closing comments.

I’ll start with some comments on our loan growth for Q2. During the quarter, we booked the total of $45 million in new loans. This total represents new loans to new borrowers and new loans to existing borrowers. We analyzed all new loans over $300,000 made during the quarter, which represented a total of $25 million. Average loan size for the new production over 300,000 was 809,000. Average note rate for these new loans was 5.35%. As the loan quality as I mentioned earlier, originated non-performing loans decreased to 1.69% and originated NPAs decreased to 1.92%. Non-accrual originated loans decreased $1.5 million from the prior quarter and the decrease was primarily due to migration of non-accrual loans to OREO and charge-offs during the quarter. Of the $1.9 million in Q2 charge-offs, $1.1 million were previously provided through specific reserves. Additionally, other charge-offs taken in Q2 would have had general reserve allowances so, the abnormally large Q2 charge-offs were largely provided for and we have recognized these losses during Q2. Our Q2 provision of $200,000 for the originated loan portfolio was essentially for the new loan growth experienced during the quarter. OREO totals remain abnormally high, but we believe still our ongoing marketing efforts, these totals will be lower at year end. Few comments on capital management, in the past six months, we have declared 2 special dividends. In December 2011, we paid a $0.25 per share special dividend and in June of this year we paid a $0.20 per share special dividend which was paid at July 24. As we have communicated several times, the overarching strategy of the company has to leverage our strong capital position through a variety of organic growth strategies coupled with continuing acquisition strategies. Our dividend strategy in 2011 was to payout essentially 100% of our profits through regular and special dividends so as not to grow our already strong capital position. If we are unable to announce any additional acquisitions during 2012, we will consider but not commit similar dividend strategies in 2012 as we did for 2011. Considering the special dividend of $0.20 paid on July 24, we will payout a total of $0.34 versus year-to-date EPS of 48% for a payout ratio of 71% for the first 6 months of 2012. Our midyear special dividend was nothing more than a capital management strategy similar and consistent with our previously stated capital strategies. To us, a special dividend is just that, a special dividend and should not be relied on or anticipated in any form, amount or time. Since the beginning of 2011 we have returned 9.9% of our capital as a percent of tangible common equity. Additionally we’ve returned a 143% of our capital as a percent of net income since January 1 of 2011. We have returned this capital through regular and special dividends as well as share repurchases. Of the total capital return since January 1 of 2011 59% was in the form of dividends and 41% was in the form of buybacks reflecting a nice balance between taxable and nontaxable return of capital. I’d like to share some key performance highlights for Q2 of 2012, ROA for the quarter was 0.95% as we’ve previously discussed and I have been discussing the importance of achieving return of average assets of greater than 1% -- greater than 1% at this point in the cycle and while we fell just short of 1% ROA in Q2 but our year-to-date ROA average is 1.1%. As Don has shared with you I believe net interest margin will continue or will get continued pressure not only for us but for the industry as a whole. Our efficiency ratio increased at 70.4% in Q2 from 67.7% in Q1 as Don has already shared with you and we understand the issues facing not only us but the industry in general as it pertains to this trend. However I would like to remind folks we had consistently stated our efficiency ratio will be higher than historical averages as we continue to build out our growth strategies. In any event we are mindful of the potential of top line revenue shrinkage due to likely margin compression which means we need to find ways to maintain the appropriate balance between growth, margin compression and expenses. As to the overall balance sheet growth, we were able to post modest growth in our originated loan portfolio in Q2 and year-to-date, that saw some deposit runoff year-to-date. The deposit runoff does not necessarily concern me. We have historically demonstrated the ability to grow high quality, low cost transaction accounts and we believe we will be able to continue to do so. During the quarter we added a senior lender in Seattle. This individual is a highly experienced lender that has successfully performed in the Seattle and King County markets for over 25 years and we expect he will substantially raise our visibility in this important market. I will close with just some few general outlook comments for the balance of 2012. I still don’t see measurable or sustainable real growth to our local or national economies. I still see consumers, businesses and municipalities focusing on de-leveraging strategies, as long as the private sector and to a lesser extent the public sector focuses on leverage, de-leveraging, which I personally believe is a good thing long term, our local and national economies will struggle with sustainable growth. Consequently high quality organic asset growth will continue to be challenging. As we have consistent reported M&A is a significant part of our growth strategies and we are well positioned for this inevitable consolidation. In the meantime we will remain disciplined and we will continue to focus on maintaining a high quality balance sheet and returning profits and excess capital to our shareholders consistent with the strategies we have outlined for you. I would welcome any questions you may have as this completes my prepared remarks and once again we refer to the forward looking statements in our press release as I answer any of these questions in the Q&A session. John, if you like to open the session for questions, I would appreciate taking few.

[Operator Instructions] And first [ph] line of Jeff Rulis with D.A. Davidson.

Brian, I wanted to kind of circle back to the efficiency ratio for sec, is that have that drifted back above 70% for the first time in over a year. Is this come a little bit of a product kind of you saw the peak benefit from FDIC deals a few quarters ago and as that peels off sort of efficiency suffers or there is some, I guess some structural expenses that could come down maybe kind of further detail, I mean you’ve sort of indicated a little bit higher than average in the near term. What leverage do you pulled it kind of correct that or get that lower?

As we know the efficiency ratio has 2 components. It has got a revenue component and expense component and I think sometimes when we look at efficiency ratio, the first thing that comes in mind is the expense side of that calculation and I am not trying to minimize expenses with my statement here. But I think that we saw the efficiency ratio get back to that 70% level again and it’s a function of both the declining revenues and essentially flat expense base. But I think to get to your question we have structural expenses within the organization. I remind folks we picked up the especially Cowlitz acquisition we picked up a number of small branches. We continue to grow those branches. We continue and expand -- our expansion efforts in Clark County, Vancouver, Washington area. As I reported to you we hired a lender in Seattle which I think is not only as I said increased our visibility. But I think is going to bring some significant new business to the organization. And so when I look at all those things and I would also say that there is probably, from an organizational point of view, there are some management structures that have been built for a larger company. And we still believe that we can grow that company, but as I said in my comments and we need to find a way to maintain the appropriate balance between growth and margin compression and expenses. I think that is a critical issue that we do need to give attention to as we go forward. But I also want to continue to create opportunities to continue that top line revenue growth and I think for a company to only focus on the expense side and not ways to grow the top line revenue I think might be shortsighted. And I’ll remind you as we look at loan growth in last year, we had some significant loan growth as a result of building out that lender base and we are growing the small branches. It's going to be a while before we get them all to the point that we like to see them from a precise point of view but we took on a significant expansion strategy a couple of years ago and we think we are executing that pretty well. And I think what I am asking for is that some patients from our shareholders from the standpoint that -- and to the extent that they believe that we are executing those growth strategies that it’s the right strategy. And I’ll close by saying that we are mindful that we’ve got to manage both sides of the expense ratio.

Okay, that makes sense. Thanks Brian. And I guess switching gears a little bit and kind of a wornout question, you sort of alluded to the M&A side, but I guess I got to ask sort of any changes in seller behavior or discussions over the last few months that would sort of alter your view of M&A kind of the back half of this year?

Well, we remain active in our discussions, probably even more active than we have been. I do -- as I said, I do see that historical spread between bid and ask narrowing, but if there are 2 -- still 2 issues that I think are not allowing M&A to take place and that’s price expectation on the seller’s part and continued marks on the portfolio. I think those 2 issues are always present and probably are always an obstacle to avoid some of our previous discussions haven’t resulted in closed transactions. We are disciplined with this process. And I think that I do see consolidation coming. I’m not going to predict when it is, because I’ve been wrong probably over the last 18 months on that point, but I will tell you that discussions continue and we remain hopeful.

Not a loan on the M&A expectations. And then just one last one if I could for Don, any chance you get hazard, I guess, on when sort of the accretion income would materially be absent the net interest income or is it just better to kind of -- the best idea is to kind of track the pace of the decline from Q2 ‘11 peak and is that a reasonable guess or could you offer any advices to when that might transition out?

Of course, Jeff, I think that it will continue to decline. It declined quite a bit from Q2 2011, but I think that was the highest. I think the rate of decline has slowed down some, but it will continue to decline and the effect of this kind of accretion will trim down, but there may be time in the quarters where they you could pop up again. So, I think we still probably got another year or 2 is a pretty good accretion on this portfolio.

And we do have a question from the line of Jacque Chimera with KBW.

Just a quick follow-up on the accretion on the M&A portfolio, to the extent that there aren’t any large payoffs in the quarter, is it a steady trickle downward?

For the overall balances?

For the discount accretion, because I know that when you get a payoff on a loan that affects it, but if you have a quarter without taking that payoff chunk out of it, does it look more even that way or is it still really volatile, even absent that factor?

I think the percentage, look at the last 3 quarters of the affected discount accretion and margins, it has actually gone up. The last 3 quarters, it was 43 basis points in Q4 of last year, 49 basis points Q1, and 55 basis points for this year, it’s actually gone up the last 3 quarters, but again if you look at year ago and it’s down from a year ago, and so overall it’s going to trend down. The percentage of accretion, if it’s going to be as affected as the rates on it, obviously the -- as the portfolios pay down, you have seen that they pay down from quarter-to-quarter. Every quarter we see those portfolios paying down -- the effect on the margin will be less, less that way. But the amount of -- I guess the accretion per acquired loan tends to be I think pretty steady.

Okay. Okay. And then Brian this one might be for you, according to my notes last quarter, I have that using the 300,000 example that you get, that the average rate that was 5.16% and then you'd said it was 5.35% this quarter. Is that a function of mix or are you able to book loans at higher rates now versus a year ago?

Sure, Jacque. First of all, I am going to trust your notes and your memory on the 5.16% last quarter, the 5.35% what is that a function of. I think we are seeing 2 things going on with the loan portfolio. We are able to book new loans today at decent yields and -- but I do see, as we have said several times now, I do see that overall margin coming down and that’s largely a function of reductions in interest rates on existing loans. The rate competition is intense out there and we continue to see competitors willing to do 5-year, 7-, and 10-year fixed rate, sub-4% lending that we are not anxious to match and we don’t often match it. But we will bring it from a current rate level to a lower rate level but not -- we don’t always match that and I will even say don’t often match that competitor rate level. So, I think in terms of back to your question in terms of 5.35%, I think we just in quarter-to-quarter comparison probably an anomaly more than anything, I would guess that that even the new loans we book going forward to that yield is going to come down. What’s 10-year treasuries today about 44 or something which was down from Q1 generally. So, I just see a declining yield issue in general.

So, if I am understanding you correctly, the bigger pricing pressure is more from the refinancing of existing clients than the effective new loans that are booked during the quarter?

By far, yes.

[Operator Instructions] And we’ve the line of Eric Grubelich [ph] with Highlander Bank Holdings.

I wondered if could clarify something when you talked about the dividend payments, the special and the regular dividend. Your management of capital and your ability to use up earnings for the year to the dividends is very good, but the buyback is that part of the plan as well to manage that to keep the earnings retention at 0.

No, I think probably to keep assuming that we keep earnings retention at 0. I think that’s largely a function of regular and special dividend and I think the buybacks, a straight buyback strategy would be to lower equity beyond that level.

Okay, that’s fine. And then one other question, you don’t exactly sound same about the local economy. When you look at your level of problem loans, do you see more of those being resolved through a TDR type of event or not.

Well, we certainly have a few TDRs and TDR creation has been fairly minimal and we don’t have a lot of TDRs in the organization. Where we have more going forward, yes I think that's a possibility. I think probably the non-performing loan resolution is going to largely be as a result of improving financial trends of the company or just resolution of the loan item managing it out or going through resolution through the collateral liquidation process. So I don’t see TDR as being a -- the bigger portion of that problem loan resolution process, if that’s your question.

Okay, that’s fine. Maybe just one last thing on the loan detail that you talked about the new and existing borrowers. Can -- you talked about the adverse side of the credits, things like that and the rate but can you give us idea of where they more in the real estate category, the commercial category, what did that look like?

Yes, I don’t have that data right in front of me, but anecdotally I think I could fairly say that it’s pretty evenly split between just your traditional C&I lending and your CRE lending and Don is nodding his head as he is looking at some data here so.

Actually, I would say over 1/2 of the new loans are actually C&I and so about $24 million of that was actually C&I, another $13 million was -- $9 million in owner occupied and other $4 million non-owner occupied, so really C&I and owner occupied, that was $33 million of the $45 million.

And we have a question from Tim O’Brien with Sandler O’Neill. Tim O’Brien: Don, on that $25 million in new originations in the C&I that you just gave, did you -- are you guys able to forward those price tag and where there any floors on a percentage of those loans that you were able to impose or…

The average rate on the C&I stuffs is a little higher, the average rate is about 586 on the C&I.

I don’t think floors are a big part of that process that pricing process much anymore, if I’m understanding your question? Tim O’Brien: Just how was it priced? Was it priced pegged primarily to the prime that’s the prime or are you guys origin is any of it LIBOR?

No, we have a few LIBOR I’m going to say probably maybe less than 5. My chief credit officer is holding up one finger. So the point is we have very few LIBOR loans. So yes they would be almost exclusively based off of prime. Tim O’Brien: And then moving on from there, you guys had a little tick-up in comp cost, was the higher of that regional lending manager, Carlos Guangorena -- did I get that right?

Yes, very good. Yes you did. Tim O’Brien: All right. Hey, was that increase tied to his hiring or is that going to be a third quarter event?

They would been a small portion. I don’t recall just when Carlos came on board, but that would have been a small portion of it. Tim O’Brien: I mean, the releases are on July 2 I think on that, but…

Yes, it’s still going to be a fairly minimal impact. I think probably, and again Don can correct me if I’m wrong here, Tim, but I think probably salary expenses probably we haven’t flow of adjusting our incentive programs up and down as performance goes up and down. So I would guess that was probably the biggest part of it, Don.

The best part of that related to incentive. In addition, we do have a few more employees this quarter than we did in the prior quarter. Tim O’Brien: And then some of that was incentive comp tied to the loan origination?

Yes, some of it would have been, yes. Tim O’Brien: And then as far as the hire was concerned, he came from -- what bank did he come from?

He came from Plaza Bank in Seattle. Tim O’Brien: Plaza Bank. And how many charges did he have working for….

It was fairly small bank, so it would have been, in terms of lenders, probably 3 to 4. Tim O’Brien: And it’s -- is the intension of management and Heritage Financial for him to build a group up there and kind of ramp? Is that the intention?

To give you a little more color on that, we’ve -- Carlos is a very experienced lender in that market, well-known to that market. He has been a major player with a couple of major banks in that area, more recently with Plaza. And Carlos is already leading our team in Seattle. We think that he has the ability to lead the team. We think he has the ability to bring business to us. We think he has ability to raise the visibility of our company in that market. And we think he has ability to recruit lenders whether they come from his previous employers or others. He has a very strong expensive contact list in that market that I think will benefit us in a lot of ways. Tim O’Brien: So, really, I guess our take could be that his hiring and management position suggest that you guys are going to grow further from there, up there, from a headcount base, from a group basis and hopefully grow the balance sheet and grow earning assets through that group you are going forward?

I’m sorry, Tim, yes, which is very consistent with what we’ve been saying since we acquired our presence in that market. We want to increase our visibility in our balances and increase the branch size and everything and we think Carlos has that ability to help us get there. Tim O’Brien: Great. A question on the NIM real quick to the new launch that came in. Were they booked late in the quarter as kind of indicated by the financials that you guys published. And if so can we get a little bit lift here heading into the third quarter on loan yield?

Well, the loans although -- the loans again were booked really at rates in a lower than in our current portfolio. So even though a lot of times rewriting of loans that we have we dropped the yields more significantly than new loans put on still at lower rates than our current overall portfolios. As far as loan yields they don’t give us a little loan yields but again the production of it -- the mix we have more loans compared to all assets and yes that does help the NIM some. And as for us throughout the quarter I think they're pretty much spread throughout the quarter. Tim O’Brien: Thanks, Don. That make sense. Last question you guys are about at the end somebody kind of touched on this. You're about at the end of your repurchase authorization. It looks like there's a little over, little less than 200,000 shares remaining.

Right. Tim O’Brien: Did you re-up this just to have it in place if the strategy warrants it that you described earlier?

Absolutely. We'll re-up it. I guess the question gets to do we do that before we get to the end of the current authorization. Obviously the answer I think would probably yes, but as I just as to when and how much probably with comment to that. But I think you say to say that when we believe that’s an opportunity for us to repurchase where we will do so.

And we have question from Tim Coffey with FIG Partners.

But I want to a little about the interest expenses do you have any chance to lower that anyway going forward?

Interest expense on deposit I'm assuming you're referring to.

All liabilities actually.

I would tell you that we have a very active process with the pricing committee that meets weekly I sit on and we look at all liabilities and we adjust our liability pricing on a weekly basis. I think we have demonstrated in the last several years an ability to react pretty quickly to changes in interest rate cycles and price accordingly. Do I believe there is more down cycle potential to the -- to our current cost of funds? Maybe. But it’s only basis points if there would be -- I don’t know what would be go down Q1 to Q2, Don, how many basis points? Four. On deposits. So, I think to rely if your question gets to and we rely on the cost of funds to assist us on the NIM side probably not.

Really what I'm looking at and what I'm seeing, there is a unique situation with borrowing cost, major expense on that is actually lower than what it is on the interest bearing deposits. So, I am wondering would it make sense to cut some of the interest bearing deposits and maybe take on some borrowing.

Tim, the borrowings, we have just repurchased -- overnight repurchase agreement with our -- with basically our customers so, there are not any other type of borrowings that we have at this point. So the basic -- they're basically secured deposit, but officially there are repurchase agreement shows the borrowing even though they're really basically different product to our deposit customers.

And gentlemen, there are no additional questions in queue.

Well, if there are no additional questions. I appreciate everyone tuning in today. I'll remind folks that we are part of the KBW conference in New York next week and I know many on this call will probably be meeting with you next week in New York. So, look forward to see you again. Thanks, John, for hosting the call and we will see all you soon.

Thank you and ladies and gentlemen, this conference is available for replay starts today at 1 p.m. Pacific Time will last until August 9 at midnight. You may access the replay at any time by dialing 800-475-6701 and entering the access code 252253, again that number 800-475-6701 and the code 252253. That does conclude your conference for today. Thank you for your participation. You may now disconnect.