Heritage Financial Corporation (HFWA) Q1 2013 Earnings Report, Transcript and Summary

Welcome to the Heritage Financial earnings conference call. [Operator Instructions] I would like to remind everyone this conference is being recorded today Thursday, April 25, 2013, and I would now like to turn the conference over to Mr. Brian Vance. Chief Executive Office, Please go ahead, sir.

Thank you, Luke. I would like to welcome all that have called in this morning and those also may listen in later to our recorded version. Attending with me this morning is Don Hinson, our Chief Financial Officer, and Jeff Deuel, our President and COO. Our earnings press release went out this morning pre-market and hopefully you got an opportunity to review the release prior to this call and as always please refer the forward-looking statements in the recent press release. I would like to start with just some highlights of our first quarter and diluted earnings per common share were $0.19 for the quarter ended March 31, 2013 compared to $0.20 for the linked-quarter ended December 31, 2012 and $0.27 for the prior year quarter ended March 31, 2012. Originated loans receivables increased $12.6 million, or 1.4%, to $887.1 million during the quarter ended March 31, and we announced a definitive agreement to acquire Valley Community Bancshares and Valley Bank. We also announced our plans to merge the holding companies 2 subsidiaries Central Valley Bank merging into Heritage Bank and the acquisition of Northwest Commercial Bank was completed on January 9, 2013, which generated a $399,000 bargain purchase. Overall this quarter had a number of moving pieces and was a solid earnings quarter with slightly better than anticipated loan growth. Don Hinson will take a few minute and cover our balance sheet and income statement changes as well as a few comments about our acquisitions accounting.

Thanks, Brian. I will start on the balance sheet. Total assets increased $101.5 million from the prior quarter end and were $1.45 billion at March 31. Net loans including car loans increased $57.1 million during the quarter and net originated loans increased $13.8 million for the quarter primarily due to $17.1 million increase in commercial business loans which is partially offset by a decrease of $3.6 million in real estate construction loans. Net purchase loans increased $43.3 million during the quarter. Purchase non-covered loan increased $45.9 million while purchased covered loan decreased $2.6 million. The increase in non-covered loans was primarily due to the Northwest Commercial Bank acquisition which had a carrying value of $49.1 million at March 31. Total deposits increased $107.1 million during Q1. Quarter-over-quarter total non-maturing deposits increased $96.1 million while CDs increased $11.0 million. The increases were due substantially to Northwest Commercial Bank acquisition which included $60.4 million in deposits at the date of acquisition. In addition approximately $26.8 million in money market deposits was added during the quarter due to one customer. These funds are expected to be drawn by the end of 2013. Our non-maturing deposit ratios continue to be a very strong 75.5% of total deposits and our percentage of non-interest demand deposits of the total deposits increased to 22.3%. Total equity increased $1.6 million during Q1. The ratio of tangible common equity to tangible assets decreased to 13.0% from 13.9% at December 31. Our tangible book value per common share increased to $12.30 at March 31 from $12.23 at December 31. This change in this metric was driven by net income for the quarter partially offset by the cash dividends in the amount of $1.2 million for the quarter. During Q1 2013, there were no shares of stock repurchased under the current repurchase program. We have approximately 704,000 shares remaining under the current program. Moving on to the acquired loan portfolio, in addition to the effects on the net interest margin which I will discuss later; during the quarter we recorded a provision on purchase loans in the amount of $363,000 compared to a provision of $419,000 in the prior quarter. The provision expense on purchase loans during Q1 was substantially due to one borrower. The change in the FDIC indemnification assets was a $267,000 net expense in Q1, 2013 compared to a $346,000 net expense in Q4, 2012. As a reminder the FDIC indemnification asset relates to covered loans obtained in the Talus acquisition. Our net interest margin for Q1 was just 5.19%. This is a 21 basis point increase from 4.98% in Q4. The increase in margin was mostly due to the impact of discount accretion on the Northwest Commercial portfolio. Our cost of fund also helped improve margin. The cost of funds of Q1 decreased to 41 basis points compared to 44 basis points in Q4. The cost of all deposits decreased 2 basis points to 32 basis points in Q1 from 34 basis points in Q4. The effects on the net interest margin of incremental discounted accretion over stated note rates on the acquired low portfolios for Q1 2013 was approximately 72 basis points compared with 48 basis points in Q4 2012. Without the effects of incremental discount accretion, net interest margin was 4.47% in Q1 compared to 4.50% in Q4. Due to continued low rates environment in which you see assets repricing faster in deposits, we expect margins to continue to overall decline in trend. Non-interest income was $2.3 million for Q1 2013, an increase from $1.8 million in Q4. This increase was due mostly to the $399,000 bargain purchase scheme recognized on the Northwest Commercial Bank acquisition. Non-interest expense was $13.7 million in Q1 compared to $12.4 million in Q4. The increase was due mostly cost associates with the Northwest Commercial Bank acquisition. In addition to ongoing cost associates with the acquisitions such as personal and branch cost, the company incurred cost approximately $665,000 and one time conversion cost and special services related to the transactions. In addition, during Q1, the company incurred approximately $148,000 of expenses related to the proposed Valley Bank acquisition. For Q4, 2012 our efficiency ratio was 72.9% compared to 71.0% for Q4. This increase is due mostly to marginal increase in non-interest expense partially offset by increases in net interest income and non-interest income. Overhead expenses are expected to remain high for the remainder of the year due to additional merger related cost associated with proposed acquisition of Valley Bank and the proposed merger of Central Valley Bank. Jeff Deuel will now have an update on overall loan growth as well as some comments on current initiatives.

Thank you, Don. With regard to loan growth during Q1 in 2013, we booked a total of $59.2 million in newer loans compared to $55.1 million in Q1 2012 and $61.1 million in Q4, 2012. These totals represent new loans and new borrowers and new loans for existing borrowers. We analyzed all new loans for the quarter. The average loan size for all new loan production was $160,000. And for loans originated over a size of $300,000; the average loan size was $1.1 million. The average note rate for new loan was 4.53% in Q1 2013 compared to 5.53% in Q1 2012 and 4.87% in Q4 2012. Although, competitive pressures are still significant, we have seen steady growth in the pipeline each month of the first quarter and we are cautiously optimistic that closed loan volume will continue to increase as well. With regard to the current initiatives, as noted earlier the Northwest Commercial transaction closed on January 9, 2013. It's important to note that system conversion occurred the weekend of March 9 and went smoothly. We subsequently moved the Lakewood branch with Northwest Commercial to our existing Lakewood branch. The former Northwest Commercial Lakewood branch location is now being marketed for sale. Heritage Bank currently utilizes Open Solutions, Inc. core operating system. After a year of review in February 2013, we signed a new contract and moved from our current Open Solutions platform to their DNA platform. It’s important to note that Open Solutions and the DNA platform are now part of Fiserv. This important system will provide a variety of efficiencies in all the operational areas of the bank. We are well underway and planning for core conversions in the fourth quarter. The Valley Bank acquisition was announced on March 11 and we have been actively engaged with management to determine staffing needs and develop a plan for branch consolidation. The corporate cultures are very compatible and we have developed a good working rapport with the Valley Team. That transaction is expected to close in the third quarter with systems conversions taking place in the fourth quarter. The merger of Central Valley Bank was announced on April 8 and is anticipated to close in late June or early July. The transaction will bring us the numbers of efficiencies and will position us to provide a smooth transition for customers and employees when the current president Mike Broadhead officially retires in April 2014. We are delighted to know that Mike will continue to work with us on the transaction through the end of 2014. The system conversion of Central Valley will occur in the fourth quarter of 2013. In addition to growth for acquisitions, we also have 3 new branch locations under development. The Kent branch building will be completed in July and will allow us to move from our leased location to a very high profile corner in the heart of Kent. The new Tumwater branch location will also position us better with the traffic pattern in that town. The existing branch buildings will be sold. Because the Kent and Tumwater branches are relocation, we do not anticipate an appreciable increase to expenses. We are opening one new branch in East Vancouver at the end of the year which will augment our existing branch in downtown Vancouver further supporting our development of that market. Finally we are proud to highlight several awards Heritage Bank has received in the past couple of months including Best Bank in the South Sound by readers of The Olympian, Best Bank in Federal Way by the readers of the Federal Way Mirror and Top Places to Work in the equity category by the Business Examiner. Brian will now have an update on loan quality and as well as some closing comments.

Thanks, Jeff, I will first start with loan quality; non-accrual originative loans increased $1.2 million from the prior quarter. The increase during Q1 was due to $2.3 million of additions to non-accrual originated loans partially offset by $994,000 of net principal reductions and $110,000 of charge-offs. $1.6 million of the $1.78 million in gross charge-offs related to a single medical relationship which was previously classified but defaulted during Q1 of 2013. The partnership unexpectedly dissolved and HIPPA rules and other issues prevented full collection of the accounts receivable. OREO decreased $403,000 during Q1 to $5.3 million. OREO related to purchased loans increased $1.1 million while OREO related to originated loans decreased $1.5 million during Q1. During the quarter ended March 31 there was an addition of 10 properties totaling $2.3 million acquired in the Northwest Commercial Bank acquisition. Three of these properties sold during the quarter ended March 31 with carrying values of $999,000. In addition the balance decreased due to the disposition of 11 other properties with an aggregate carrying value totaling $1.8 million. Other than assets acquired from Northwest Commercial acquisition there were no additions to other real estate owned during the quarter ended March 31. The ratio of allowance for loan losses to non-performing originated loans decreased to 151% from 170.4% at the prior quarter end. Potential problem originated loans were $25.1 million at March 31, a decrease of $3.2 million from $28.3 million at December 31, 2012. Even though our overall allowance to originated loans has been decreasing, we still maintain a very healthy allowance of 2.02% to originated loans and just indicated our allowance to non-performing loans continues to be a strong 151%. I’d like to comment on capital management. As a reminder for the past couple of quarters we have employed a 3 pronged to managing our capital levels. Regular dividends, special dividends and stock repurchases. We’ve also discussed that acquisition activity were to increase, we would consider reducing or eliminating the special dividend. Our acquisition activity has increased recently with the closing of the North West commercial bank transaction in January and the announced Valley transaction in March. Assuming Valley closes, our tangible common equity from both acquisitions will have been reduced from 13.9% on 12/31 to approximately 11.7%. As a result of this recent activity, it is likely we will reduce or eliminate our special dividend strategies for 2013 and we will continue our current regular dividend strategies. We will continue to consider stock repurchases when we deem it and then pages to do so. I’d like to comment on some key performance considerations for the balance of 2013. I would like to offer some additional comments on the points Jeff made earlier on the important initiatives for remaining part of 2013. The effects of these changes would be as follows. The Central Valley Bank charter merger will allow for substantial improves scales and efficiencies. The expense saves from the CVB charter merger will not be realized until later this year as the both merger and the conversions are completed. We are estimating CVB charter merger will provide approximately $500,000 in annualized expense reductions. When the Valley transaction is closed we anticipate additional scale on efficiencies for the combined company substantially improving assets for employee. The core system conversion will allow for significant efficiency gains through improved operating systems as well as an improved customer experience. The new core system will also provide a stronger platform to support future growth. We have already identified a reduction of 12 staff members and have communicated this to the affected employees. A reduction through individuals will take place later in Q2 and 9 will take place in early Q4. We are estimating onetime acquisition and overhead expenses for the Central Valley Bank and the Valley bank strategies to be approximately $2.5 million which will occur throughout the remainder of 2013. We are acutely aware of the need to continue to improve efficiencies and to reduce overall operating costs. We are optimistic that we can identify additional cost reduction opportunities as we integrate our acquisitions and continue to employ our efficiency strategies. And now for a general outlook for 2013, I look for the economy in 2013 in the Pacific North West to continue to improve. Seattle continues, still continues to be strong but outside of Seattle we see pockets of slower growth and improvement, I believe home values will continue to slowly improve primarily as a result of substantially less inventory and stable demand. I also believe that most end commercial real estate sectors will continue to improve however retail commercial real estate valuations maybe slower to balance that. As previously discussed our originative non growth should be in the 3-5% annual range. Q1 NOIs were slightly stronger; rightly 3-5% is still an appropriate range. I believe we will bank M&A activity in the Pacific North West will continue to grow in 2013 but still not at robust levels. That completes our prepared remarks and I would welcome any questions you may have and would once again refer you to our forward looking statements in our press release as we answer any of these questions dealing with potential forward looking issues. Luke, would you like to open up the call for questions.

[Operator Instructions] Your first question from the line of Jeff Rulis, Davidson.

I just wanted to get a sense of how we should look at expenses, what like a good run rate would be for the year with all these initiatives and additional costs going forward?

Well, I will give a kind of an overview comment and Don can fill in some details. I think that's going to be a very difficult question to answer with all of the initiatives that we've got going. I think we're beginning to see some benefits of that as I shared with you in terms of some staff reductions and when we think of the Central Valley Bank charter merger, the valley bank coming online and costs associated with the assimilation of those 2 items, a systems conversion and costs associated with that as well as cost save, I think it's going to be very difficult for us to discuss specific run rates, Don would you have any addition to add?

Well, I would say that again we mentioned that we had about $800,000 and kind of acquisition related costs. In addition this last quarter -- in addition you know there were some more employees because we kept some of the Northwest Commercial bank staff into conversion within March. We do have some reductions, this is really hard to give you run rate again you know far down the road you’re looking because again we talk about, we’ve got about $2.5 million just an additional costs associated with the acquisitions and mergers throughout the rest of this year, so giving you a run rate for this year it’s a little tough right now but I hope I supplied you a little bit of color at least on kind of adjustments through the current quarter.

Yes that’s helpful and then my next question would just be like how is loan production there and April has still been improving at the same rate as you mentioned in the first quarter with the loan pipeline?

I think we’re optimistic that as I said earlier that we can stay within the previous guidance in terms of what we thought we might get in loan growth this year. Loan growth is slightly better than we’ve anticipated in Q1, you know. It's difficult; we managed 2 numbers when dealing with loan production. One is a pipeline of loans and 2 is loans that have been approved but not yet booked or funded. Both those numbers continue to improve and if we can continue to have a pull through rate as it has been the last few months, I’m hopeful that we can continue to show some good loan growth, but I think that’s 3% to 5% for the total year it’s still a pretty good number.

Your next question will come from the line of Tim O'Brien of Sandler O'Neill & Partners.

This is actually Andrew Liesch on for Tim. Just to clarify, all the Northwest Community Bank expenses, those are already in the numbers, there is nothing left?

Yes as far as the like conversion costs, yes that's true.

Brian, just comparing this release to towards the end of last year, it just seems like your tone has improved, I am just curious if there is anything more specific you can point to about why that may be compared to just the general comments you had at the end of your prepared remarks?

You know, I think there's probably 2 really obvious reasons for that. One is that we continue to see improvement in the economy, asset values, primarily real estate asset values are continuing to improve. As I said there is pockets of obviously stable valuations whereas others are showing some improvement. I think that gives us some encouragement. The C&I sector continues to struggle a little bit. I think the C&I side of things lag from the standpoint of their revenues and improving substantially and our net profit. But overall, I think I continue to be encouraged as to just the general trend of economic improvement. Nothing robust but just a nice steady improvement. And I think a second thing obviously is our succession with the 2 acquisitions that -- the one that’s closed and then the Valley transaction that's been announced. I think those 2 transactions will substantially assist us with, as I have said and many times now the last couple of quarters in looking at improvement in scale and efficiencies, and we have an efficiency ratio that we are not comfortable with and clearly it is much higher than it has been historically. But I think with the 2 acquisitions driving the scale on efficiencies, and as I have said several times too; I think over the last couple of years we have been focusing on building an infrastructure, and prepare it for what we are experiencing now. And that’s welcome these acquisitions. So I think as we integrate these acquisitions and really be able to see the benefit of the scale on efficiency improvement, I think we will start to see, have some significant improvements to expenses as we move to the latter part of this year, and certainly in the next year. So as I reflective big picture, those are the 2 things that I think give us marked encouragement over, let’s say 2012 and ’11.

Just one quick question on the Central Valley merger, are there any revenue synergies you might get there, or maybe larger legal lending limits?

There is always a possibility that we certainly haven’t built that into our assumptions. In the past we have always Heritage Bank, has participated in Central Valley Bank overlyings and those relationships would exceed our legal authority. So Central Valley has effectively tapped into our increased capital base as a result of that. So I don’t see marked improvement of synergies in that regard. I think really the improvement is going to be just the elimination of the redundancies that we have with 2 charters and redundancies and process, redundancies in policies, redundancies in everything we do, certainly will add to and help again the overall efficiencies of the combined company.

Your next question will come from the line of Tim Coffey of Fig Partners.

I have a question about the net charge-off levels. You have been high; you are rather elevate the last couple of quarters and I am wondering what's causing that and is this kind of the new normal?

It's hard to say of the new normal Tim, I think as I have said many times; loan quality is not always linear. Whether it's up or down; I think at certain quarters, there is going to be some anomalies, I think when we take a look at the overall improvement of the portfolio, it continues to improve. I think that the last couple of quarters; the losses that we have seem that have been higher than the last couple of years probably or at least several quarters, it's primarily coming from the C&I sector and as I commented just a moment ago, I think that we continue to see a softness in the C&I sector in terms of their revenue growth expenses, profitability; those sorts of things. So I think that's a sector that continues to show a bit of weakness but I do think that as I think I said in the earnings release, I do believe that they are outliers and I think that we'll continue to show overall improvement as we go forward over the next several quarters.

So, the charge-offs aren't coming from any specific banks?

No, I don’t believe so.

Okay, the M&A related expenses, you discussed presuming your comments there Brian; is there anything that which has those expenses to either decline or entry beyond what you estimated? The merger related expenses that you discussed at the end of your comments. If that would cause them to be less or more than what you’ve forecasted.

Well again I will give you the big picture and Don can you give us some specific color. We've indicated that we're anticipating about $2.5 million in total merger related expenses for the balance of the year. Now, that includes expenses involving the CBB charter merger as well as bringing Valley online. There were I think about a $150,000 of Valley’s expense in Q1, certainly the larger share of those integration expenses are going to come in Q2 and Q3. But Don, do you have any additional thoughts on that?

Well Tim these are obviously estimate and the bigger number you have like that the more you supposedly could miss dollar-wise but I think they are good estimates, I think they are somewhat conservative as far as I think we can, those are the numbers that we can hit as far as those cost. But there are some assumptions that whether or not that I guess plan totally finalizes as far as potential branch consolidation and the cost there but we still have made some good estimates in that one.

Okay but my thought process is this is not the first time you have done this, these conversions or these integrations, so maybe there were efficiencies in there, that your estimates you might be too conservative?

Well, you are right. This isn't the first time we've done it. I think we do have a pretty good ability to estimate costs associated with these mergers as well as efficiency gains. So, a little more difficult to project efficiency gains because especially with Valley, we are just at still in the planning process and trying to determine how those 2 organizations, how we'll bring those 2 organizations together. But I really do believe and I am quite optimistic that we can drive overall scale and efficiencies as we go through the change of control and conversion process through the year.

Okay and then one last question on just the overall M&A environment, obviously things are coming across your desk, you're getting deals done. Has the pace of opportunities slowed at all recently?

I wouldn’t say that it's slowed. as I said in my prepared comments, I don’t look for a robust M&A activity in the Pacific Northwest this year but I do see levels of M&A activity in ’13 being higher than they were in '12 and I would they will even be higher in ’14 and ’13. So I think that there is probably a fairly steady activity in that regard.

We have a question on the line from Jacque Chimera of KBW.

Brian, specifically follow up on the thought you were just finishing, what do you think, I mean what I guess are you are looking for to see that M&A activity really pickup and I guess maybe into 2014 and beyond that?

I think as I have indicated with general economic improvement in the Pacific Northwest which I’ve spoken to the as I said by improvement in asset value as well asset values improve, marks decrease and I think that was probably one of the things that prevented a lot of acquisitions happening and let’s say open bank acquisitions in ’11 and ’12 because of the uncertainties with asset values. The marks were just too high and I think that discouraged a lot of potential sellers. As those marks are coming more and they are certainly higher than historical norms but they are much lower than they have been I think that is the primary reason why M&A activity will continue to strengthen. I see those marks continuing to improve and as those marks improve I think discussions and actual deals will get done whereas previously I think discussions happened but when you got through with the marks it kind of brought a couple of deals probably to where they wouldn’t happen. So that's the primary reason why I see more activity there Jackie.

Okay and I am guessing that improvement in the market is what’s driving some of the really nice movement you have had out of OREO in the last, call it couple of quarters or so definitely the last quarter?

Yes that's a fair assumption.

Okay and then just one kind of housekeeping item, I noticed there was a small little reclassification in fees during the quarter, and I just wonder what moved from Other, end Q1 service charges?

I am going to ask Don to help us with that one.

Jackie I think we did that in Q4 actually…

Okay.

I think we combined kind of 2 line items together so we did some reclassification, it might not have been in the earnings release but it was in the 10-K.

Okay I must have missed it in the K then. Okay so just kind of a cleanup and making things a little more streamlined?

Correct.

[Operator Instructions] And Mr. Vance, I am showing no further questions at this time.

Okay thank you Luke and I would certainly thank everyone that I had an opportunity to call in today I appreciate your continued interest in the company thanks for calling and good bye.

Ladies and gentlemen, this does conclude the conference call for today. We do thank you for your participation and your conference call will be available for replay starting today and ending May 9th you may dial in to the replay by dialing toll free 1 800-475-6701 and entering access code 287972. Again international participants may dial area code 320-365-3844 or toll free North America 1 800-475-6701 and access code 287972. That does conclude our conference call for today. We do thank you for your participation and for using AT&T executive teleconference. And you may now disconnect your line.