Heritage Financial Corporation (HFWA) Q2 2013 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by and welcome to the Heritage Financial and Investor Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Brian Vance. Please go ahead, sir.

Thank you, Roxanne, and good morning to all. Well, good morning on the West Coast. Good afternoon to those of you on the East Coast. I’d like to welcome everybody that has called in and also those that may listen in later in the recorded mode. Attending with me this morning is -- are Don Hinson, our Chief Financial Officer and Jeff Deuel, our President and Chief Operating Officer. Our earnings release went out yesterday afternoon, and hopefully you had an opportunity to review the release prior to this call. And also the earnings release has a forward-looking statement that I’m sorry that we will not read this morning but was part of the press release. I’d like to start with some highlights of our second quarter. Diluted earnings per common share were $0.18 for the quarter ended June 30 compared to $0.19 for the linked quarter ended March 31 and $0.21 for the prior year quarter ended June 30, 2012. Originated loan receivable increased $45.4 million or 5.1% to $932.5 million during the quarter ended June 30. Non-performing originated loans decreased to 1.05% of total originated loans at June 30 from 1.34% at March 31, 2013. Heritage completed the merger of its 2 subsidiary banks with Central Valley Bank merging with and into Heritage Bank effective June 20, 2013 and Heritage declared a regular cash dividend in the amount of $0.08 per share and a special cash dividend in the amount of $0.10 per share. Overall this quarter had a number of moving pieces consistent with our overall strategies for 2013 and we are particularly pleased with the better than expected loan growth. Don Hinson will take a few minutes and cover our balance sheet income statement changes as well as a few comments about our acquisition accounting. Don?

Thanks, Brian. I’ll start with the balance sheet. Total assets decreased $21.4 million from the prior quarter end and were $1.43 billion at June 30. The decrease in assets was primarily due to a decrease in cash and cash equivalents which decreased $52.1 million as they were used to fund loan growth because of a decrease in deposits. Net aggregate loans including both originated and acquired loans increased $31 million during the quarter. Net originated loans increased $45.5 million. The increase was due primarily to increases in non-owner occupied commercial real estate loans and C&I loans. The portion of the increase in non-owner occupied commercial real estate loans as well as the decrease in commercial construction loans was a reclassification of a large multi-family residential construction loans whose construction phase was completed. Net purchase loans decreased $14.5 million during the quarter. Purchase non-covered loans decreased $8.1 million while purchase covered loans decreased $6.4 million. Total deposits decreased $28.6 million or 2.3% during Q2. This decrease during the second quarter is not usual. In the second quarter of 2012 but also experienced a 2.3% decline in total deposits. Our non-maturity deposit ratio continued to be a strong 76.1% of total deposits and our percentage of non-interest demand deposits, total deposits increased to 22.9%. Total stockholders’ equity remained relatively unchanged at $200.5 million. The ratio of tangible common equity to tangible assets increased to 13.2% from 13.0% at March 31. Our tangible book value per common share decreased slightly to $12.26 at June 30 from $12.30 at March 31. During Q2, 2013 there were no shares repurchased under the current repurchase program as we are precluded from repurchasing stock during Q2 due to the Valley transaction. We have approximately 704,000 shares remaining under the current repurchase program. Moving on to the effects…

Thanks, Don. With regard to loan growth during Q2, 2013, we booked the total as $75.1 million in new loans compared to $44.7 million in Q2, 2012, and $59.2 million in Q1 2013. This total represents new loans to new borrowers and new loans to existing borrowers. We also analyzed our new loans for the quarter, the average loan size for all new loan production was $220,000 and for loans originated over a size at $300,000 the average loan size was $1.3 million. The average no rate for new loans was 4.84% in Q2, 2013 compared to 5.63% in Q2, 2012, and 4.53% in Q1, 2013. While loan production was up in the second quarter, competitive pressures are still significant although our pipeline is holding steady at this time. We do not expect to see the same level of loan volume in the second half of the year. With regard to current initiatives, you know the Northwest Commercial transaction closed on January 9, 2013, and conversion occurred on March 9, after conversion we consolidated one branch into an existing Heritage Bank branch. The asset that was carved out of the original purchase transaction was subsequently sold in June and we are in the process of distributing the proceeds to the former shareholders as outlined in the definitive agreement. We also announced the merger of Central Valley Bank on April 8, 2013, and change of control occurred on June 20. This transaction will bring us a numbers of efficiencies and will position us to provide a smooth transition for customers and employees when the current President, Mike Broadhead, officially retires on April 2014. Mike will continue to work with us on the transition in a part-time role through the end of 2013. The system conversion for Central Valley will occur in…

Thank you, Jeff. Excuse me, I’ll start with the loan quality comments non-accrual originated loans decreased $1.9 million from the prior quarter. The decrease in the non-accrual originated loans is due to $2 million of net principal reductions, $647,000 of charge-offs and $438,000 of transfers to other real estate owned partially offset by $1.1 million of additions to non-accrual originated loans. OREO totals decreased to $1.5 million during Q2 to $3.8 million, the decrease was primarily -- was due primarily to proceeds from the dispositions of 8 properties totaling $2 million partially offset by additions of 5 properties totaling $513,000. During Q2 the company recognized a net gain of $60,000 on the disposition of other real estate owned and a negative valuation adjustment of $85,000. The ratio of the allowance for loan losses to -- excuse me, I’ll start over. The relation -- the ratio of allowance for loan losses to non-performing originated loans increased to 183% from a 151% at the prior quarter end. Even though our overall allowance to originated loans has been decreasing, we still maintain a very healthy allowance of 1.91% to originated loans. As credit quality continues to improve our ratio of the allowance for loan losses on originated loans to total originated loans is likely to continue to decrease. In fact, the second quarter -- provision for originated loans was solely due to our originated loan growth in the second quarter. Due to continued overall credit quality improvement without the originated loan growth we would have not required a provision for originated loan loss since for the second quarter. I’ll have some comments on capital management as a result of the Valley Bank change in control on July 15, our tangible common equity have estimated to be 11.8%, a reduction from 12.31% TCE of…

[Operator Instructions] Our first question comes from the line of Jeff Rulis.

Brian, I had a question on the loan growth and sort of the timing of that, was that evenly dispersed throughout the quarter, or was it sort or back-end loaded in the fact that maybe you get a benefit on margin into Q3?

Fairly even, Jeff, there may have been a slight distribution to the latter half of the quarter but it wouldn’t have been a marked difference.

Okay. And then maybe one for Don on the -- could you remind us on the expected goodwill and CDI from Valley?

I think we were looking at about $16 million in additional tangibles.

And then the pro forma TCE?

11.8.

Great. And then Don just a clarification on the margin, your commentary about expected decline, now that’s -- you are referring to the core margin?

Yes.

And our next question comes from the line of Jackie Chimera.

Brian, I just wanted to touch base on the loan growth, and I knew that you generally have a pretty conservative stance on everything. And I wanted to see what changed between the 3% to 5% that you had thought was going to be 2013 versus the strong growth you’ve had and then the projection for 2H to be 4% to 6%?

Yes, projections are kind of just that, they're projections, and I think that we certainly were pleasantly surprised with the growth in Q2. As we’ve discussed in the past we do monitor and track our loan pipeline and that loan pipeline has been building nicely really kind of at the end of last year steadily through the first and second quarter of this year. I think probably one of the things that surprised us a bit or that was stronger than historical was the number of loans that go from the pipeline to actual bookings. Now you would obviously understand that the pipeline is a projection of potential closings. Not all deals close. Maybe they are competitive when the rate were, maybe they -- maybe there is some underwriting issues that cause a deal or 2 to fall out. But I think the bottom line is we just had a really high hit ratio of those loans from the pipeline flowing through and actually booking in a much higher hit ratio than I think we’ve had historically. Certainly the growth was nice to see and I think we appreciate it. But I -- that’s I guess how I'd probably characterize why it was so much stronger over maybe our annual projections.

Are the applicants that you are receiving, are they stronger credits than they have been in the past?

I don’t know that they are any stronger from a borrower strength point of view I will say as I noted just with the Pacific Northwest economy we are continuing to see improvements in the economy. I think those improvements are helping and reflecting in stronger trends for our borrowers. I think it’s also reflecting valuation stabilization in the real estate valuations and maybe even improvement in some sectors of the commercial real estate markets and I think all those flow through to higher appraisals. Previously maybe, we wouldn’t get the appraisal that we had thought we would get, and so the deal falls out of the pipeline because it doesn’t meet our underwriting standards as it pertains to loan to value levels. So I think all of that together kind of just coalesce into a very strong quarter. And I will again caution folks, obviously Q2 growth is not going to continue into the balance of the year, but you probably also heard my comments. I think we will have stronger growth the last half of the year than maybe we anticipated earlier this year. For the -- all reasons I just noted, improving economy, improving real estate values, improving trends for our borrowers, those sorts of things.

Okay. That’s really good and helpful. And I just have one last question for Don. I just wanted to make sure that the -- there is no liability or anything attached to the income statement with the workout of the REO property that’s transferred back related to the acquisition?

No, there is nothing left on the books for that.

[Operator Instructions] We have a question from the line of Tim O’Brien. Tim O’Brien: That $75.1 million in new loans this quarter, was some of that draws on existing lines, I know that you said that the funding went that new and current existing borrowers, but was that -- did that include were those of all underwritings, new underwritings or was there draws on existing lines?

It was primarily new underwritings. It would have been also new loans to existing borrowers. So… Tim O’Brien: They were underwritten.

Yes. Tim O’Brien: Okay, all right, great. And then could you ever sense of what the average yield was on the new production?

Yes, it was 4.84%, which actually was a little stronger than Q1 average production, average let me restate that, Q1’s average yield on new production was 4.53% so it was almost 30 basis points stronger than Q1, Q2 over Q1. Tim O’Brien: And what’s behind that, Brian? Do you ever sense of why that was?

Not a specific reason, we’ve got a list of loans here, and we are looking down through the -- Jeff and I looking down through the rate sheets and the rates of these loans and it’s just a -- it’s a little bit of everything. I said and we said all along and it continues to be a very competitive rate market out there. But I think our leaders do a pretty good job of maintaining yields on our loans, and we’re comfortable with the quality of the new production we’re putting on. But I think when you take a look at our non-accreted loan margin and look at it historically it’s probably getting much higher than -- I won’t say much but I will say higher than our peers, which I think speaks to our ability to sell the trusted financial advisor aspect to our borrowers and may be get a little bit more than others do from a yield perspective. Having said that, it’s still a very competitive market. Tim O’Brien: Sure. That’s great. And then I can back into this, but you might have it just handy, do you have a -- know what the core yield was excluding accreted yield for your loan book this quarter kind of the average yield, what was that?

Yes.

Don, yes, we'll have that for you in just a moment. Tim O’Brien: Thanks for doing the heavy listing for me, Don.

That was the loan yield? Tim O’Brien: Yes.

For this… Tim O’Brien: Excluding accreted?

Right, that was a 547. Tim O’Brien: 547.

Yes. Tim O’Brien: Great. And then, how big was that loan that transferred to IOCRE from multi-construction?

That was $14 million.

Just give you little more color on the loan yields. In the first quarter, though, we also had a loan close, a pretty large loan close that was a tax exempt loan. And it was at a lower rate because basically we get a tax equivalent rate for on the bottom line but when it hits the loan yields it was the lower so I think that’s one reason why first quarter’s was also little bit lower so that’s why. We’ll just see an increase. Tim O’Brien: Was there anything else in the contribution to that 5 -- or to the generation of that plus 47 core yield that was one-time in nature?

No, I don’t think so. Tim O’Brien: Okay. Last question on your comment Brian on expected efficiencies from the Valley Bank deal being over and above what had been previously mentioned, can you remind us what the last previously mentioned quantification of that was that you’ve made. I think you'd said something like 40%, 50% there. What was that number I forgot?

Yes there is a couple of that -- a couple of numbers here. And one is this, we announced cost savings for the Valley transaction at 45% to 50%. Now there is as we -- as we get into that obviously we’ve had a change in control, we’ve been continuing with looking at staffing and branch consolidations we still remain very confident that that number can be achieved. Now, when in my formal comments in this morning when I said that the Valley efficiencies are over and above what I had previously announced, that was just specifically talking about the -- and in fact I read that comment again: we have closed the Central Valley Bank charter merger and streamlined various functions in the company, eliminating 7 FTE and announced an additional FTE reduction of 12 for later this year. So that’s just with the initiatives within the Heritage Bank and the Central Valley Bank charter merger. So the Valley will -- we believe will bring efficiencies over and above that, but again… Tim O’Brien: Over and above the Central Valley, okay.

Yes, but I will also state that -- the 45% to 50% cost saves we still remain confident of. Tim O’Brien: One other last question. As far as the process for the conversions, all the conversion, systems conversions that are going to take place in the fourth quarter, so assuming that since the overall bank is going to a new system right in the fourth quarter, Heritage proper?

Yes, that’s correct. Tim O’Brien: You’ll do that first or will you do it all the same time or kind of there is some execution process in this. Could you just give us a little color on that. It sounds like it’s a little bit -- could be a little bit tricky?

Sure. I’ll give you a big picture, maybe ask Jeff to respond to it as well. We’re going to stage it, we’re going to convert Central Valley and Heritage in the middle of October and then we’re going to convert Valley in November. I will remind you, we’ve already converted Northwest Commercial. I think the big picture here is that I think we've got a team that’s pretty well versed in bank conversions as this is our first -- our fourth acquisition in the last 3 years. And I think we’ve got a fairly seasoned team, and we’ve got a very systematic process of what we’re doing. Yes, I agree Tim there is always a risk with a systems conversion, but at this point everything is on schedule and we feel pretty good about the process. I’ll ask Jeff to add a little bit more color to that.

The only thing that I would add is that currently Heritage Bank and Central Valley Bank have separate servicing platforms, but they’re identical, they’re both on OSI. So, when you think in terms of converting 2 banks, we’re really doing the conversion planning in parallel for both organizations. And the Valley Bank conversion will be from Fiserv which is a system we have converted from another transaction so we’re somewhat familiar with that servicing platform. And I would add to that we’ve been planning for this for about 9 months and we’re feeling fairly confident about it at this point we’re taking it quite frankly a month at a time. Tim O’Brien: It’s a more robust platform you’re going to, I would imagine, and is it cost kind of I guess for I don’t know dollar of asset managed what have you, is it more expensive?

No, actually the way I’d like to characterize, and Don may want to jump in on this, is, it’s going to bring us a lot of internal operational efficiencies. It’s a platform that’s easier to maneuver within for our team. It’s "open architecture," so it’s easier to change, and I think at the final analysis, the savings that we’re going to get from moving to the new platform tend to offset the cost of moving to the new platform.

Tim, we’re going to be -- we’re going to have some costs that -- some upfront cost that because of probably contract we amortized over a certain time period, but overall it shouldn't really affect bottom line and still add efficiencies and products to the customer. So, as far as the costs of system goes, we really shouldn’t see that hit the bottom line. Tim O’Brien: How long is the earnback, Don?

Well, I mean, on the earnback again it’s -- with our amortization and depreciation expenses on this, there is no additional costs. I'm not quite sure you mean by earn back on that. Tim O’Brien: You mean if there is -- I guess since you're amortized -- okay. So, the net, once the system is transferred and up and running and operational, is there is going to be a net efficiency gain right out of the gate?

Yes, I mean going forward because these things are basically capitalized the non -- the effect on non-interest expense will be negligible if any. There won’t be any one-time costs -- substantial one-time costs associated with this because most of the costs are -- are being capitalized and, yes, appreciated. Tim O’Brien: I know these capitalized costs are going to be offset by the lower cost of operating the system so there is going to be net improvement and efficiency or the costs are going to be incrementally lower right out of the gate is what you’re saying, right?

That’s what we're modeling, yes.

And, Tim, it’s Brian. I would just add one additional comment on the conversion process. We are going from a -- from an Open Solutions platform to their DNA platform, but it’s all within the Fiserv company. Fiserv owns Open Solutions and so we’re staying within the same company. So I think we’ve got some leverage on our provider we’re not going from a separate company to a new company and therein you get a little bit of finger pointing. I think that’s significant, and we know the Fiserv system very well, and the Valley Bank conversion is coming out of the Fiserv system as well. So, you are correct there is -- there's always risk with systems conversions, but again I think we’ve got a nicely experienced team and we’ve done this several times before and we’re staging the process and we’re pretty confident that we can do what we’re projecting to do.

And we have a question from the line of Tim Coffey.

Can you give a rundown again of all the non-recurring or one-time expenses you anticipate in the next 2 quarters?

Yes, Don will help you with that.

Well, Tim there is -- again we are estimating about $2 million. It’s the nature of the cost are the conversion cost of the Valley Bank because they are on a different system so we’re going to convert ours. We will also have some -- as we close some branches, we’ll have some lease buy-out cost associated with that, and then there will also be some still -- we have some fees still associated with the acquisition that will run through -- because we didn’t close it until this month, they will be running through this quarter, some of those costs. So those are kind of nature of the, the main nature of the costs.

And the bulk of that is going to -- there will be some costs as Don just indicated in Q3, but I think the bulk of it is going to be at Q4.

The conversion cost and the lease buy-out cost will occur in the fourth quarter.

Okay. The bulk -- is there a percentage breakdown you could give me?

Well I would say probably 75-25. 75% in the fourth quarter.

Okay. And then Brian, so if you look at you have your core expenses relative to the asset, the average assets. It was still elevated this quarter but it seems like it was lower compared to previous quarters. Do you feel like that, on a core basis, that’s the kind of trend that you are starting to develop or is it too soon to tell?

Well, the short answer is yes, I think that is a developing trend that I think will continue I think we’ve been pretty consistent over the last several quarters talking about a, the need to strategically improve overall cost and b, I think we’ve been demonstrating that the last 2 quarters with merging in the Central Valley Bank charter and making other FTE reductions in the company and as I indicated in my comments, I think Valley is going to bring even more efficiency. So yes, I -- we very clearly understand that we’ve got to improve our efficiency ratio and as I indicated after we back out the one-time expenses, I think we're at a little over 68% efficiency ratio. So that is a trend that I think is going to -- it’s not going to be a linear progression because there is going to be some -- all of these expenses, expense saves just don’t happen every quarter, but I think that I can pretty confidently say that, that our efficiency ratio at least on an adjusted basis through the balance of this year is going to continue to improve. And the 2 acquisitions that we have done, when you take a look at the improvement and assets per employee that we bring over on a net basis after the branches are consolidated and after the FTEs are consolidated, really do improve assets per employee for -- and average deposits per branch for the total company. All that feeds into improved efficiencies.

Great, all right. And then just kind of a question, do you have any kind of target level of cash equivalents going forward in terms of your dollar amount or percentage of earning assets?

So they will go up probably this next quarter even with the cash price paid for the cash piece of the Valley acquisition because they were less leveraged. They have a larger cash position relatively percentage wise than we did and a larger investment portfolio percentage wise. So I think that it may go up a little bit this next quarter, but obviously I like it to be less than it was prior to the quarter before. So somewhere in between those -- in that range somewhere.

And maybe to add a little more color to that, we were right around 90% loan to deposit ratio at the end of Q2. I think we’ve given guidance that we would like to be in that 85% to 90% range. I think pro forma with Valley were going to be somewhere in the 85% loan to deposit range. Now there is a couple of things that -- we like the liquidity that Valley brings to our balance sheet as evidenced by the loan to deposit ratio that gives us increased loan lending capacity, and I think there will be increased lending capacity for their lenders for enhanced product and also higher legal lending limits. And I think that just as we look at and the fact that we’re going to be consolidating some branches, we are modeling some deposit loss, which would be expected in that process. So I think that as we go through the next several quarters, I think we’ve got the opportunity to use that increased liquidity for just growth in the company. So I think we feel pretty good about that structure.

Would that kind of loan to deposit ratio be something you would want to carry say in 2014 once you are sort of past the branch consolidations?

I think that we would like to operate in that 90% range. I think we’ve been fairly consistently in that range. Acquisitions move that needle up and down as you move to the process, but I think that 90% range is where we would like to be. And I want to -- just one other comment, Don made the comment about deposits slipped in Q2 but very similar to, almost an identical percentage change as Q2 last year, so that is just something that happens and now we are anticipating deposits will gradually build as we work through the balance of this year. So on a cyclical basis, it’s up and down, and of course the Ag lending is up and down, and that affects it as well, but 90% is kind of that range we’d like it to be.

And Tim, if you are looking for a number, I would estimate that we'll probably end up between $100 million and $120 million of cash and cash equivalents kind of going forward.

And at this time there are no other questions in queue.

If there are no further questions, I’ll remind our investors that we will be in New York City next week, Don, Jeff and I, for the KBW Conference. And we’ll probably be seeing many of you investors at that conference. So we'll look forward to seeing you then. Thanks for tuning in on today’s call. I appreciate your continued support. Thank you.

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