Heritage Financial Corporation (HFWA) Q1 2012 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by, and welcome to the Heritage Financial First Quarter Earnings Release Conference Call. [Operator Instructions] I would now like to turn the conference over to our host, President and CEO, Mr. Brian Vance. You may begin.

Thanks, Lindsey, I appreciate that. I'd like to welcome to all those that have called in and those that may be listening in later on a recorded version. Attending with me this morning is Don Hinson, our CFO. Earnings press release went out this morning before market opened. Hopefully you've had an opportunity to read the release prior to the call. I'd refer you to forward-looking statements and the recent press release. And for the record, I’d like to read just a short statement on forward-looking statements. Statements concerning future performance, developments or events, expectations for growth or market forecast 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 effect of interest rate changes; risks associated with acquisitions of other banks and opening newer branches; the ability to control costs and expenses; credit risks of lending activities, including changes in level and trend of loan delinquencies and write-offs and 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 forward-looking statements and we undertake no obligation to update any such statement. The company does not undertake or specifically disclaim any obligations to revise any potentially forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statement. Additional information on these and other factors are included in the company's filing with the Securities and Exchange Commission. I'd like to first discuss some highlights of our first quarter. Our diluted earnings per share increased to $0.27 for the quarter ended March 31 from $0.14 in the prior quarter ended December 31, 2011, and from $0.05 in the prior year quarter ended March 31, 2011. Return on average assets increased to 1.24% for the quarter ended March 31 from 0.65% for the quarter ended December 31, 2011, and from 0.23% for the same quarter in the prior year. Increased quarterly cash dividends to $0.08 per share for the second quarter from $0.06 per share for the first quarter of 2012. Nonperforming originated loans decreased to 1.88% of total originated loans at March 31, 2012, from 2.57% at December 31, 2011. And nonperforming originated assets decreased to 1.95% of total originated assets at March 31 from 2.14% at December 31, 2011. Net interest margin increased to 5.35% for the quarter ended March 31 from 5.18% for the prior quarter ended December 31, 2011, and 5.08% from the prior year quarter ended March 31, 2011. Non-interest demand deposits at March 31, 2012, increased to 20.6% of total deposits compared to 20.4% at 12/31/2011, and 17.2% at March 31, 2011. We posted Q1 net income of $4.17 million or $0.27 per share, which was an increase from Q4 2011 net income of $2.23 million or $0.14 per share. Our total loan loss provision for Q1 was a negative $109,000, 0 for the originated loan and a negative $109,000 for the purchase loans compared to Q4 provision of $3.3 million, $195,000 for the originated loans and $3.1 million for purchase loans. Net recoveries on originated loans for Q1 were $246,000 compared to net charge-offs of $265,000 in Q4 of 2011. Our originated loan loss allowance to total originated loans increased slightly to 2.69% at March 31 from 2.66% at 12/31/2011. Overall, I believe this is a solid earnings quarter with nice improvements in the net interest margin and credit metrics. 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 first start off with going over some balance sheet items. Total assets increased slightly from the prior quarter end and were $1.37 billion at March 31, 2012. Net loans decreased $13.6 million during the quarter due to decline in the balance of acquired portfolios. Total net originated loans remained basically unchanged for the quarter, decreasing only $824,000 during the quarter. The decline in loan balance was partially due to $4.3 million of loans transferred to other real estate owned. Total deposits increased $3.5 million during Q1. Quarter-over-quarter total non-maturity deposits, which are total deposits less all CDs, increased $18.7 million, while CDs decreased $15.2 million. Our non-maturity deposit ratio continues to improve, is now a very strong 72.4% of total deposits. In addition, the percentage of non-interest demand deposits to total deposits has increased to 20.6%, up from 20.4% at the end of Q4. The continued improvement in our deposit mix has resulted in lowering our costs of -- all deposits to 46 basis points for Q1 2012, down from 47 basis points in Q4 2011 and down from 67 basis points in Q1 2011. Total equity increased $3.1 million during Q1. The ratio of tangible common equity to tangible assets decreased to 14 – sorry, increased to 14.1% at March 31 from 13.9% at December 31. Our book value per common share increased to $13.29 at March 31 from $13.10 at December 31 and our tangible book value per share increased to $12.36 at March 31 from $12.16 at December 31. The increase in these metrics was driven by the $4.2 million in net income for the quarter, partially offset by a combination of cash dividends in the amount of $927,000 and stock buyback in the amount of $114,000. During Q1 2012, 9,000 shares of stock were repurchased at an average price of $12.67. During the quarter, we recorded a provision for loan losses on purchase loans in the amount of a negative $109,000. This reduction in provision expense was due substantially to the increase in estimated cash flows in certain pools of acquired loans and the original cash flow estimations. The change in FDIC indemnification asset was a negative $176,000 in Q1 2012 compared to a positive $327,000 in Q4 2011. As a reminder, the FDIC indemnification asset relates to covered loans obtained in the Cowlitz acquisition. Cash flows on acquired portfolios continue to be re-estimated on a quarterly basis. Our net interest margin for Q1 was 5.35%. This is a 17-basis point increase from 5.18% for Q4 2011 and a 27-basis point increase from 5.08% in Q1 2011. The effect of the net interest margin -- on interest margin of the incremental discount accretion over stated note rates on the acquired portfolios of Q1 was approximately 49 basis points. This compares to 43 basis points in the prior quarter ended December 31, 2011, and 32 basis points from Q1 2011. Without the effects of incremental discount accretion, net interest margin was 4.86% in Q1 compared to 4.75% in Q4 2011. The increase in margin was substantially due to strong originated loan growth in the latter part of Q4 2011. In addition, the margin was impacted by loan repayments during the quarter that resulted in increased loan fee income from the acceleration of the related unamortized loan fees. Interest reversals on non-accrual originated loans impacting the net interest margin for Q1 were approximately 8 basis points compared to 9 basis points for Q4 of 2011 and 11 basis points for Q1 2011. Our focus on non-maturity deposit growth and pricing strategies continued to drive cost of funds lower, which has also contributed to a strong net interest margin. Our cost of funds for Q1 was 57 basis points compared to 58 basis points for Q4 and 82 basis points for Q1 2011. Our non-interest income was $1.9 million for Q1 2012 compared to $2.9 million for the prior year Q1 2011. The decrease from prior year is due substantially to the effects of the change in the FDIC indemnification asset. I just want to make a note that Merchant Visa income and Merchant Visa expense are now reported net in non-interest income. Previously, Merchant Visa expense was reported as non-interest expense. For comparability purposes, prior periods have also been netted. Non-interest expense decreased $485,000 to $12.6 million for the quarter ended March 31, 2012, compared to $13.1 million for the prior quarter ended March 31, 2011. The decrease was due to decreased other real estate owned expense in the amount of $261,000, decreased data processing expense in the amount of $232,000, decreased FDIC insurance expense in the amount of $181,000, and decreased loan expenses in the amount of $173,000. These were partially offset by a $561,000 increase in salary and benefits expense. Non-interest expense control will continue to be a focus of ours. However, continuing growth-related expenses and other expenses such as loan resolution cost will make it likely that we will see a higher than historical efficiency ratio over the near term. For Q1 2012, our efficiency ratio was 67.7% compared to 65.1% for Q4 2011. Brian will now have an update on overall loan quality changes and loan growth as well as some closing comments.

Thanks, Don. I'll speak to maybe loan growth first. During Q1, we booked a total of $55 million in new loans. This represents new loans to new borrowers and new loans to existing borrowers. As we have the last several quarters, we analyzed all new loans over $300,000, which represented a total of $36.5 million, and the average loan size for this new loan production was -- over $300,000, was $831,000. Average note rate for these new loans was 5.16%. The total loan production for Q1 2012 was almost identical as Q1 2011. As Don mentioned earlier, total loans declined on a linked-quarter basis, but this decline was entirely due to shrinkage of our acquired portfolio. Loan production’s typically low in Q1 and met our expectations. Speak to loan quality for just a moment. Originated non-performing loans, as we've discussed, decreased to 1.88% and originated NPAs decreased to 1.95%. Non-accrual originated loans decreased $5.1 million from the prior quarter. This decrease was primarily due to the condominium project that went into lender and possession receivership during the quarter ended March 31, 2012. Due to the receivership status of the project, the company transferred $3.8 million into other real estate owned and recognized a charge-down of $445,000. We are pleased with this development as we can now begin marketing this project. Our coverage ratio remained strong at 143% at the end of the quarter, which is up from 103.5% for Q4 2011, and our allowance to total originated loans at the quarter end was a likewise strong 2.69%. As stated previously, our coverage ratio has been consistently well over 80% and will likely remain so. Quarter-over-quarter cash flow estimations for our acquired portfolios remained fairly stable. And therefore, no provision expense was necessary for Q1. While we believe that provision for acquired loans will be – while we – I’m sorry, while we believe that provision for acquired portfolios will be substantially less in 2012 than 2011, we may still see some valuation volatility reflected in future re-evaluations that may cause moderate provisions for these acquired portfolios. Provisions for our originated portfolios for the past several quarters have reflected our generally improving credit quality trends and we also expect substantially less provision for our originated portfolios in 2012 than 2011. I'd like to highlight some key performances for you. Return on average assets for the quarter was 1.24%. I've been discussing the importance of achieving a return on asset of greater than 1% at this point in the cycle, and the important thing to consider with this ROA performance is it was created without reserve release from our originated portfolio primarily due to a small net loan loss recovery of $246,000. Our originated loan loss allowance actually went up on a linked-quarter basis and we had a very minimal $109,000 negative provision from the acquired portfolios. Return on average equity for the quarter was a respectable 8.19%, especially considering our strong equity position. We continue to post strong non-accretive net interest margin, and as Don already noted, our non-accreted net interest margin was 4.86% for Q1, up 11 basis points from Q4. While we have been predicting a narrowing margin, we still believe we will see some margin compression as we go through the balance of the year. Speak to capital management for just a moment. We are well aware that we have a strong capital position and we still remain positive that we will be able to leverage our capital into new growth opportunities. We increased our dividend from $0.06 to $0.08 and based on yesterday's stock close at $12.92, this $0.08 equates to an annualized dividend yield of 2.5%. As we have shared in the past, we continue to maintain a growth bias. But so that we don't grow on already strong capital base with increased profitability, management continues to consider our dividend strategies. A general outlook for the balance of 2012. We continue to see pockets of improvement, but improvement is sporadic and unpredictable. As a result, we will not see – we are not likely to see linear loan growth until we achieve a more robust economic recovery. More specifically, the magnitude of our loan growth in Q4 surprised me more than the flat growth we reported for our originated portfolio in Q1. I indicated in our Q4 earnings conference call that I thought our loan growth would be muted in the first half of this year but will hopefully pick up in the latter half of this year, and I still believe that. I believe we will continue to see sporadic and unpredictable organic loan growth for the foreseeable future. The most problematic area of concern continues to be housing. It was recently noted that 40% of the home sales in King County or the Seattle area are distressed sales and 50% of the home sales in Pierce County or Tacoma are distressed sales. And Zillow, a nationally recognized online source of home values, recently announced the following: “A definitive national bottom of the housing value decline by the early 2013. Nationally, the average home values are down 24.6% since their peak in May of 2000 and are now at the same level as in late 2003.” Zillow further predicted that the Seattle MSA would continue to slip a modest 1.3% through the balance of this year. We will see pockets of marked improvement in home values in various markets, but the broader market of home values in the Pacific Northwest have not yet stabilized. As I have said for the last 2 years, we must see home values stabilize as well as sustainable improvement to unemployment before I believe we can see sustainable, measurable recoveries. Having said all this, I do believe we will see marginal improvement in the Pacific Northwest economy in 2012. Our go-forward strategies are: continue to focus on quality organic loan growth. I believe we will continue to improve overall credit quality and credit costs. We will focus on leveraging our capital through ongoing capital management strategies, organic growth and acquisitions. The number of troubled banks continues to remain compelling, but they do not yet have a catalyst or sufficient motivation that convinces me that they should sell at – that convinces them that they should sell at discounted values. Troubled bank deals will be done on our terms. I remain convinced that consolidation will happen. And when it does, we're prepared to execute. In the meanwhile, we will remain focused on growing organically, improving our financial metrics and returning an attractive yield to our investors through our capital management strategies. I continue to believe there will be attractive opportunities for the well-capitalized and well-positioned banks in 2012 and beyond. I would welcome any questions you may have and once again refer you to our forward-looking statements in our press release as I answer any of these questions dealing with forward-looking comments. So with that, Lindsey, that completes our prepared remarks, and we would open the conference call to any questions that our participants may have.

[Operator Instructions] Our first question coming from the line of Jeff Rulis from D.A. Davidson.

Question, Brian, on the provision, I guess the non-covered loan loss provision barring a significant worsening in credit, safe to say that you'd expect a modest or zero provision until loan growth picks up?

Jeff, as I indicated with my general economic discussion, I think there’s still volatility in the market. And as I closed my economic section by saying I believe that there’s going to be -- 2012 will improve over '11. I think there is still some volatility in the market. We haven't seen a sustainable measurable improvement that I would like to see. So as a result, I don’t think I can say that there’s going to be – I would be comfortable in saying there's zero provision, but certainly modest provision, as we go through the year on the non-covered originated portfolio. I would be comfortable with that.

Okay. And, Don, maybe just a question on the tax rate, again popped above 31. I don't know if I had this wrong. I don't know if you've got it to a high 20% number. But should we just be using the 31-and-change or how is that outlook?

Well, I think that most of the reason for the impact we have the Municipal securities is an adjustment for our tax rate. In the prior quarter, I think we were up around 30 on our tax rate. But that was, again, our income was a lot higher and therefore the impact of the tax-exempt securities has lessened. So at this income rate, yes, it's going to be up in the 31s. If our income comes down some, it’ll be more 30 to 31, but maybe 31 or 31-and-change is a good estimate at this point. But again, that income is kind of fixed and its impact on our tax expense is really based off our net income for the quarter.

Okay, and then on the expenses and this is probably a more longer term question and, Don, I think you mentioned the efficiency ratio of sort of higher than historical. But I guess if you look at your run rate at $12.5 million on non-interest expense, is that room to push that lower or is that just sort of a cost structure that you're hoping to grow into?

Well, I think at this point, it's a cost structure we're looking to grow into. Again, we still have some smaller branches through the acquisitions that we did in 2010. So I think it's probably a cost structure we're looking to grow into. There was always opportunities for some cost saves, but at this point in our kind of growth mode that we’re in, I don't see that going down a whole lot.

And, Jeff, I would add too that even though we didn't talk about it, our strategies are -- under the organic growth strategies, we continue to look at opening new branches in certain market areas. I think there’s -- we're always looking for new lenders. We're probably not going to have the new lender growth we had in the last 18 months. But I think it's likely that we will add new lenders as opportunities present themselves. And if we were to, for instance, even be able to bring on a team of lenders, I think that's a possibility as well. And so I think there’s a variety of things that probably just, as we’re looking to grow strategies, that is likely to keep the efficiency ratio higher than historical norms.

Okay. And then one quick last one on the acquired or purchased loan balance. How is that --- should we just assume the runoff that you saw through the bulk of the – well, the last couple of quarters is sort of the run rate or is that stabilizing? How do you see that through the next year?

Well, we have seen some runoff in the last couple of quarters. I would say that the runoff will slow at some point, not sure it's going to necessarily be this next quarter. But we are continuing to work through some of the more problem credits. If they go to other real estate owned, obviously they come out of the portfolio there if they get worked out, credits that we don't want get worked out. So I think there’s still a few of those. But I think at least towards the end of this year, I think that’ll quite stabilize.

[Operator Instructions] Our next question comes from the line of Tim O'Brien from Sandler O'Neill & Partners. Tim O’Brien: So from a margin perspective as far as the contribution from the covered loan portfolio, was the additional increase that you got this quarter, I guess surprising to you given the guidance you guys had been giving the past couple of quarters for downward pressure?

Well, again, the acquired portfolio did show some improvement in pockets. We had no – in fact, probably overall it did show improvement. The fact that we did increase the yield on that portfolio. So the accretable yield increased on that. At the same time, we didn't take any provision expense. So I think overall, the portfolio improved in its estimations and cash flows for the quarter. Going forward, again, we think it's stabilizing so I mean, there’s always going to be pockets where we could give some provision. But we did provide quite a bit last year. And again, we had one nice quarter of some stability and I'm hoping that going forward that we can continue to see some more of that. I don't think it will go up a lot more, the accretion on that. But if we have again another quarter where it improves, we'll see even higher accretion on that. But if it goes the other way some then there is likely not to see higher accretion. So again, we’ve seen some volatility. We'll continue to see some more. I think this quarter was the least volatile that we've had so I'm hoping that we'll see some more of that. Tim O’Brien: And then again, Don, you also said that your kind of outlook is sans a couple of credit runoff rate in the acquired portfolio is likely to ease up a little bit. And by extension, can we assume that cash flows on those loans are going to -- you're going to generate less kind of cash flow capture from these discounted loans by extension as a result of kind of a slowing of the runoff there? And so the contribution to the margin might be less here going forward, possibly a little bit as well?

Yes, I mean, overall, the balances will continue to go down. I think the pace of the decline will slow. But if you think about it long term, they're probably not going to be considered in the SOP accounting, the acquired loan accounting, forever. At some point they’ll be performing and they’ll change the basis of a note. They’ll be rewritten, and at some point, they'll probably come off being accounted for under acquired loan accounting. We really haven't seen much of that. So the loan growth we've seen on the originated side has not been kind of loans moving from the acquired portfolios to the originated portfolios. At some point, I think we'll see some of that because a lot of these credits are good credits that we want to keep long term. Tim O’Brien: You bet. And then last question. The dividend increased to $0.08. Is that a dividend that's going to hit here – pay in the second quarter? Starting in the second quarter?

I'm not sure I understand your question, Tim. Tim O’Brien: It's payable in May.

Okay, got it. Yes, that's right. May 21?

May 24, I believe.

Our next question comes from the line of Jackie Chimera from KBW.

Don, I have a question for you. I know we've done a lot of passing out in the margin in the past and I just want to make sure that I’m looking at these loan yields correctly. If I strip out the accretable yield, I'm calculating a net loan yield of 6.25% in the quarter compared to 6.17% in the fourth quarter. Does that sound right?

Yes, that does sound right, Jackie.

So given some of the loan growth that, Brian, I think the average rate you quoted was 5.16% for some of the larger loans that you've booked?

Yes. For the new loans that we booked – excuse me, Jackie, just to clarify that, that was 5.16% for the new loans booked in Q1.

Oh, in Q1. No, wait, no, we just finished. Now I’m all confused. Sorry, we just finished Q1. Okay. I guess my main question is what was the main driver of the core loan yield expansion? It's one of the few that I've seen this quarter.

Well, I think part of it has to do with -- even though quarter-to-quarter on a focal date we didn't see originated loan growth, but we booked a lot of -- we added a lot in the fourth quarter, as you know, and we had quite a large increase in loans during the fourth quarter. And a lot of that happened in the last half of the fourth quarter. So we didn't get the full impact on that until this quarter. And that's a big driver of it. There were also some prepayments of some loans that had some unamortized loans fees, that got accelerated this quarter. And that also did have some impact on the loan yields for this quarter. But we did book a lot of loans in the latter half of Q4 that we had full impact for this year.

And, Jackie, candidly, I would have to tell you that, that originated loan non-accreted yield going up in Q1 over Q4 surprised me as well.

Okay. So to the extent that you can answer this, would there have been the linked-quarter expansion absent the acceleration of that yield? I'm sorry I'm not voicing this very well. It’s been a long earnings season. Absent the fee income, not the new mix of the loans, but absent the other income component, would the loan yield still have accelerated just based on the growth?

No, I don't think they probably would have. I think the loan yields themselves – I think the margin would have but I don't think the loan yields themselves probably would have gone up like they did without that.

Okay. So positive, the loan yields benefited from the additional income, but the overall margin also benefited from the mix from the prior quarter. Okay, I've got it now. And then just one last question. So absent -- if the transfer of the OREO hadn't happened during the quarter, the net recoveries would have been even higher. Is that correct? Looking to charge-offs?

Can you say that one more time, Jackie?

Since you had booked the charge-off on the transfer of the OREOs, the recoveries in the quarter would have been even higher than their current level if that loan hadn't been charged down.

Well, yes. We would have had a higher net recovery if we hadn't charged down the ...

Yes, I see what you're saying. Yes, that's correct. Yes.

Our next question comes from the line of Joe Steven [ph] from Steven Capital [ph].

Actually both Timmy O'Brien and Jackie asked my questions sort of about the acquired loan portfolio margin.

[Operator Instructions] I'm showing no further questions.

Okay, thank you, Lindsey. I appreciate everyone calling in for our conference call this quarter and appreciate your continued interest in our company. With that, we'll close our conversation today.