Heritage Financial Corporation (HFWA) Q4 2007 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial Corporation earnings conference call. (Operator Instructions) I would now like to turn the conference over to your host, Brian Vance. Please go ahead.

Good morning, everyone. Thanks, Greg, for the introduction. As Greg indicated, I'm Brian Vance, CEO of Heritage Financial Corporation. Joining me today is Don Rhodes, our Chairman, Don Hinson, our CFO, and then also Ed Cameron, our Corporate Secretary. Hopefully all of you out there have the earnings release that went out yesterday, and I would like to welcome all of you and thank you for your attendance and interest and calling in and being a part of our conference - earnings conference call today, and certainly those that may be also tuning in later on a recorded basis. As always in these sessions, I will refer you to the forward-looking statements in the press release and in fact, I would like to read this real quickly so it is a part of the recorded record. This release includes statements concerning future performances, developments or events, expectations for growth and market forecasts and other guidance on future periods. Forward-looking statements are subject to a number of risks and uncertainties, and they 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 acquisitions of other banks and opening new branches, the ability to control costs and expenses, and general economic conditions. These factors could affect the company's financial results. Additional information on these and other factors are included in the company's filings with the Securities and Exchange Commission. Thank you for bearing with me through that. I'd like to just give you a few highlights of our fourth quarter, and incidentally, I've got about 10 to 15 minutes of prepared comments and then certainly we will open it to questions and answers - questions here a bit later. Well, hopefully some answers as well. Highlights of our fourth quarter: Net income was up 8.5% over the same quarter comparison. Diluted EPS for the fourth quarter were $0.42, a 10.5% increase over Q4 of 2006. Linked quarter non-interest expense decreased nearly 2% - 1.9% to be exact - and Q4 2007 non-interest expense was 1.5%, lower than Q4 of '06. Continuing strong credit quality with non-performing assets at 0.13% for December of 2007 compared to 0.36% for December 2006. Other financial metrics are - and [inaudible] we'll come back and address many of these metrics with my comments, but some other metrics would be 2007 diluted EPS was $1.61 compared to $1.60 for 2006. Our ROE for 2007 was 12.9% compared to 14.2% for 2006. Efficiency ratio for the total year increased to 62.6% for 2007, up from 61.9% for 2006. And finally, net interest margin for the year was 4.5% compared to last year or 2006 at 4.83%. Maybe I can just speak to earnings and EPS growth a bit. Although the linked-quarter earnings strong growth, our year-over-year earnings and EPS were essentially flat with just a $0.01 EPS increase year-over-year. Our year-over-year margin compression of 11 basis points was the primary cause of our flat earnings, and I'll address the margin a bit more later. I'd like to speak to balance sheet growth. We reported a 9.4% annualized asset growth for the first three quarters of this year, but the year ended with 3.9% annual loan growth. As indicated and starting near the end of the third quarter, as indicated, actually, in the press release, but staring near the end of the third quarter this year, we began to position our balance sheet for what we believe will be increasing challenges in the local housing industry. Also as I indicated in the earnings release, we began to make balance sheet decisions late in the third quarter to not only not grow our construction portfolio but to begin to selectively reduce it. This, coupled with a few large commercial real estate loans that unexpectedly paid off during this period actually reduced our loan totals by about 3% over Q3. This reduction in assets allowed us to be a bit more aggressive with some CD pricing that caused deposits to decline about 1.2% over Q3 as well. We believe that with the current economic conditions, balance sheet growth for at least the first six months of this year will be modest. Continuing to diligently manage our overall portfolio credit quality will be a high priority for the organization this year. Net interest margin - as I indicated on a linked-quarter basis our net interest margin contracted by 11 basis points. This was primarily caused by a rate reduction of our prime base loans due to the fed rate decreases we've been experiencing in the last several months. And it also is the result of some deposit lag pricing that is typical in not being able to reprice our deposits as quickly as the loans reprice. Additionally, we've been aggressively repricing our deposits since the rate cuts, but again, this lag will continue to cause some modest margin compression in the short run. For approximately the last six months, we have been decreasing the duration of our CDs and as a result, we will have the benefit of a substantial bucket of CDs repricing in the first six months of this year. Non-interest expense - as I indicated earlier, our total non-interest expense decreased by nearly 2% on a linked-quarter basis. This is consistent with stated objectives of continuing to reduce our overall non-interest expense. As we go through 2008, we will continue to focus on controlling this expense level. Efficiency ratio - as I just indicated, our linked-quarter non-interest expense improved, but our efficiency ratio actually increased slightly. This has primarily affected our top line revenue or our net interest income declining on a linked-quarter basis. And of course that was associated with declining loan balances as well. While we continue to focus on reducing expenses, our efficiency ratio is not likely to improve appreciably until we can stabilize or even grow our net interest margin or to begin to grow our balance sheet and earning assets as well. Loan quality - we are pleased with our overall asset quality. As I indicated earlier, our non-performing asset level decreased to a very low 0.13% of total assets. At the same time, the deterioration we are seeing in the housing industry with increasing inventory and completed houses and subdivision lots is causing us some concern. The majority of our builders and developers are well-seasoned customers of ours that have managed through previous economic downturns. And while the vast majority of our builders and developers are currently performing on their loan commitments, we are seeing strains of increasing inventory and a slowdown in sales which negatively impacts critical cash flows. We are working closely with them to assist them through these difficult economic times. Because of our very low non-performing asset level and due to the housing industry difficulties, our non-performing asset levels are likely to increase, however, our decisions to limit our construction exposure relative to many of our peers, we believe, has been a good strategy. Return on equity - no question, it's our goal to improve this number, and we want to get back to our long-term goal of 15% ROE. To do so we will need to improve our margin and balance sheet growth while continuing to manage expenses aggressively. In the near term, though, strategic and prudent asset growth is our primary goal. Capital management - we will continue to evaluate our cash dividends quarterly, but our primary position on managing our capital remains unchanged, and that is to preserve capital for growth opportunities. Additionally, preserving some capital for future opportunities once we get through this economic cycle, we believe, is a good strategy as well. Subprime - much has been said and written about subprime woes in our national and global economies, and while this is a huge national problem, we have not engaged in any subprime lending and do not have any balance sheet exposure to subprime-related issues. Perhaps if I can just give you a few comments on our 2008 outlook, and then I'll be happy to open it up to any questions you may have. In 2008 we'll continue to focus on our C&I relationships as we have for the past several years. On the same token, we are beginning to see some spill over into some C&I businesses that are closely related to the housing industry, and it'll be important to closely manage these relationships as well. Continued commercial lending officer recruitment will be a focus. Just today, or actually yesterday, as a major 2008 initiative of ours is that we are rolling out a new checking account acquisition program, and we believe this will assist us in growing our checking accounts and non-interest deposit totals and the associated fees, service fees, along with this particular initiative. As we've reported in the past, we have a temporary branch in Sumner that has been open for the past year or so, and on February 13 we'll be holding a groundbreaking for that permanent facility that we'll be building and hopefully occupying late this year or early next year. Overall, we feel we have done a very good job of positioning our balance sheet for 2008. Even though we know there are economic challenges facing us, we believe we are poised to leverage this positioning as we move through the year. That completes my prepared comments, and I'd be happy, Greg, if you would open it for questions, and I'll attempt to answer those questions.

Okay. (Operator Instructions) Your first question comes from the line of Jim Bradshaw from D. A. Davidson. Please go ahead. Jim Bradshaw - D. A. Davidson & Co.: Good morning.

Hi, Jim. How are you? Jim Bradshaw - D. A. Davidson & Co.: I'm well, Brian. Thanks for asking. A couple questions. It sounds like something in the delinquency or classified buckets leads you to think you're going to have a little bit higher NPA number going forward. Can you talk about how delinquencies or classifieds have changed from Q3 to Q4?

Jim, I guess I was a bit tongue in cheek with the remark that it's hard for us to go down from our current level because it's just essentially zero, so if they increase at all, it will be going up. But I like the position we have in terms of our - just our overall non-performing assets. Our delinquencies have not gone up. Our delinquencies for the entire year average less than 0.5% of total portfolio. December was less than 0.5% for the month. So we're not seeing any delinquency issues in the portfolio as of this point in time. But I think as we look at economic cycles, and I think, if for any reason, just the fact that the housing industry is typically slow during these months - December, January, February - I think we're going to continue to see some increasing weaknesses there, and perhaps the past-due percentages may climb a bit. On the non-performing asset side - excuse me, on the criticized asset side, we have seen a little bit of increase in the non-performing assets on the construction loan side. Again, these loans are performing. I think we probably are a bit more aggressive than some others in recognizing weaknesses to credits and moving those to watch lists and criticized status, et cetera. So while we've seen a modest increase to that, my comments really, Jim, just get to what I just have to believe is going to be some continued weakening to the housing industry. Jim Bradshaw - D. A. Davidson & Co.: Brian, is there much of a variance in sort of economic conditions or credit quality trends from the sort of north to the south of your franchise? Is Pierce worse than Olympia, for example?

Well, I think Pierce County is, from a housing industry point of view, is showing more weaknesses than certainly our market here in Thurston County or Olympia, Pierce County, for the East Coast folks, being Tacoma specifically. That market, I think, has some overbuilding in inventories. We see about 9.5 months worth of standing inventory today in the Pierce County market, and I think that's a number that we've got to help our builders work through. So, again, when you look at all the economic factors, it's hard for me to be positive to say that our construction portfolio, although relatively small as compared to peers, is not going to continue to have some issues that we'll need to work through. And that's really the reason for my cautionary launching. Jim Bradshaw - D. A. Davidson & Co.: Yeah, $1 million in non-performers on a $900 million bank isn't a big issue, I guess, at this point, is it?

I would agree, Jim. Jim Bradshaw - D. A. Davidson & Co.: Talk about loan pipeline and maybe, you know, what types of production. I'm a little surprised to see you had some CRE payoff. Just wondered if that was, you know, things being sold rather than conduit funding or things like that. If you can give us a little flavor for what loan demand looks like, that'd be helpful.

As to the [inaudible] real estate, we had some - a couple of fairly sizeable payoffs. And interestingly enough, Jim, they were conduit. That is the first conduit activity that we have seen in some time. Now, we've had some discussion, is that conduit activity, is that the beginning of more conduit? You know, we all understand that the last several months, the conduit markets have pretty much dried up. Jim Bradshaw - D. A. Davidson & Co.: Right.

I think there are some insurance companies out there that are still playing in that arena and are available to do some still long-term fixed-rate pricing that we're not willing to do in those cases, so while I don't think that's going to be a big issue, it has caused us a little bit of a short-term concern and it's something that we're monitoring. As to the loan pipelines, again, cyclical. Pipelines are typically down this time of year. I think we're seeing some opportunities in the commercial real estate sector in terms of pipeline opportunities for a couple of reasons. I think the commercial real estate sector here is still pretty strong. And also, with some recent changes in rates, I think those interest rates are pretty attractive to some investors out there on the commercial real estate side, so I think that's an opportunity that presents itself from a pipeline standpoint. Jim Bradshaw - D. A. Davidson & Co.: Okay, good. And then maybe you can talk a little bit about margin, how much - what's sort of the size of CD repricing opportunities you have over the first half of the year. And have you, Brian, have you guys built a lot of floors into your loans, so are you starting to see loans hitting floors?

You know, I'll ask Don maybe to address the CD bucket issue. But the floor issue, that's one I would love to be able to tell you, Jim, that we have floors in all or many of our loans. We have found it difficult from a competitive point of view to get floors in our loans. I'll tell you that strategically, it is something that we're considering, and we're asking our lenders to attempt to get those floors embedded in their loans. But I can't tell you that that's going to be a saviour for us if rates continue to decline. As to the CD buckets, as I said, we have been managing those durations shorter and shorter all the time for at least this last six months, and so I really think that that strategy is going to pay dividends to us as rates continue to come down. I want to add one more thing to the floor before I ask Don to address some of the CD repricing issues and that is our Central Valley affiliate does have floors in most all of their loans. On a percentage-wise basis, it doesn't have a big impact, but they in that marketplace have been much more successful in getting floors. Don, in terms of the CD bucket?

Yes. We have most of our repricing within the first six months of the year. In fact, of about $350 million in CDs, we have approximately $300 million we're repricing the first six months. So we'll be taking advantage of a lot of that repricing as the rates go down early this year. Jim Bradshaw - D. A. Davidson & Co.: And Don, that's mostly coupons in the 5s? Is that where those were?

A good portion of them. Jim Bradshaw - D. A. Davidson & Co.: Okay.

High 4s maybe. Jim Bradshaw - D. A. Davidson & Co.: Okay. And then the last question I had is the tax rate was a little low in Q4. Is that just a true up or have you hit a new magic level on taxes?

No, that was somewhat of a true up. We make estimates throughout the year. We true them up a little bit a year end. Jim Bradshaw - D. A. Davidson & Co.: So it's still 33, 34 is right for '08 expectations?

Yes. Jim Bradshaw - D. A. Davidson & Co.: Okay.

I would say what - the overall rate for '07 is what you want to use for '08. Jim Bradshaw - D. A. Davidson & Co.: Perfect. Thanks very much. Appreciate it.

Thanks, Jim.

Your next question comes from the line of Ross Haberman from Haberman Fund. Please go ahead.

Good morning, gentlemen. How are you?

Ross, we're doing well. How's things in New York City this morning?

Nice, but cold.

Okay, good.

You threw out a statement regarding the efficiency ratio, that you're not going to be able to squeeze more out of it. Is that - do we need another round of the Sheshunoff guys to come in before that happens?

Specifically, Ross, no, I don't think we need another round of that. I will speak to this, though. You know, on a linked-quarter basis, our non-interest expense went down, and it has for the last little while. But our efficiency ratio goes up, so why - how does that and why did that happen? As I said in my comments, it's top line revenue, it's margin driven. Our efficiency ratio at this point is more margin driven or top line driven than it is by the expenses. Not that it isn't important to manage the expenses. We have been, and we'll continue to do that. I think just the reality of likely continued net interest margin compression will just force that number to not improve much in the short run. I'd love to be able to tell you a different story than that, but I think that's just the effect of the numbers. But I think as a company, you will and can expect us to continue to manage our expenses aggressively. And until the - you know, again, we've got a pretty good opportunity with this big bucket of CDs repricing, and to the extent that we can hold some of the yields on the loan side, stabilize our margin, and boy, knock on wood, and hopefully if we could just increase that margin a little bit, that's what's really going to drive our efficiency ratio down below that 60 number in the short run.

If we see more refis - I should say, are you beginning to see that? And will you keep - I should say, will that help the non-interest income line; will the fee income be easier? I guess you're originating them and selling them. Or will it hurt the spread because you might see a number of your residential refi and hurt your interest income.

Yeah, you know, our existing mortgage, portfolio of mortgage relationships - and again, that's a very well-seasoned portfolio of existing customers that performs incredibly well - that's a relatively small part of our balance sheet. It's around $50 million or maybe even something less than $50 million. So to the extent that some of those refinance - and then certainly we know that 30year rates are getting very attractive, and that could be a saviour on some of the issues on the other side of the housing industry issues - but I think just - I wouldn't expect that refis within our existing portfolio will be much of an effect on our margin. To the extent that we can originate some mortgages to drive noninterest income and gain on sale or brokerage income, that could be a bit of an improvement as we work through this year. Did I answer your question?

Yes, just one other thing. Any new branches planned for '08?

I'm sorry?

Any new branches planned for '08?

Yeah, as I indicated, we'll finish the construction on the one new branch we announced a year ago, but there are no new ones on the docket for '08. I do think, though, that we have been and we will continue to look for opportunities for new branches. Typically, as we've chatted before, Ross, one of the things that, when I enter a new market, I'd rather do it with people than a building, people first. And so if we have an opportunity to find a team of folks in a market that's on our radar screen, that could happen. But I don't see anything on the horizon at this point.

Okay. Thanks, guys.

Thanks, Ross.

(Operator instructions) And at this time, there are no further questions.

Great. Thank you. I appreciate you hosting, and I appreciate everyone's interest and calling in at this point in time. Again, as I've looked at 2008, I think we've positioned our balance sheet. I think we have a balance sheet that has high quality of assets, and I think that we have some opportunities to leverage this position. And as we go throughout the year, it certainly would be our intent to do everything we could in that regard. So thanks for your interest today, and I'm available for any one of you to call me at any time to discuss what I can absent full disclosure issues. So anyway, I appreciate your attendance, and we'll see you next go around. Thank you.

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