Heritage Financial Corporation (HFWA) Q4 2016 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for your patience and standing by. Welcome to the Heritage Financial Year End and Quarterly Earnings Conference Call. At this time, all participants phone lines are in a listen-only mode and later there will be an opportunity for question. [Operator Instructions] And just as a reminder, today's conference is being recorded. I'll now like to turn the conference over to Chief Executive Officer, Brian Vance.

Thank you, Justin, appreciate it. I'd like to welcome to all that called in this morning for our earnings conference call and also to those that may listen in later. Attending with me this morning in Olympia is Don Hinson, our CFO; Jeff Deuel, our President and COO; and Bryan McDonald, Chief Lending Officer. Our earnings press release went out this morning pre-market release and hopefully you've got an opportunity to review the release prior to the call. And as always I would ask you to refer to the forward-looking statements in that press release, both for our prepared remarks this morning and also as we go into the Q&A following our prepared remarks. First of all, I just like to highlight fourth quarter and the annual 2016 results. Diluted earnings per common share were $0.33 for the Q4 '16 compared to $0.32 for Q4 '15 and $0.37 for Q3 '16. Diluted earnings per common share were at $1.30 for the yearend December 31, '16 compared to a $1.25 for the year end at December 31, '15. Yesterday we declared a regular cash dividend of $0.12 per common share. Return on average asset was 1.03% for the year and return on average tangible common equity was 10.84% for Q4 '16. Total loan receivables net increased $60.9 million or 2.4% during Q4 and increased $237.4 million or an even 10% from December 31, 2015. I'll turn the call over to Don Hinson to take a few minutes to cover that financial statements result. Don?

Thanks, Brian. I'll start with the balance sheet. As Brian mentioned, we had another strong quarter of loan growth with net loans growing 9.5% on an annualized basis for Q4 and year-to-date loans grew 10% in 2016. Our loan-to-deposit ratio increased to 81.2% from 78.9% at the prior quarter end, this is the highest reported loan-to-deposit ratio since the merger with Washington Banking company in 2014. During Q4, the percentage of demand deposits to total deposits increased to 27.3% from 26.7% at the prior quarter end and total non-maturity deposits to total deposits increased to 88.9% from 88.6% at the prior quarter end. We continue to see a decrease in CD balances due to continued low rate environment. The investment portfolio decreased 24.5 million during Q4, this was due primarily to 21 million of net unrealized losses recognized during Q4. These unrealized losses impact the total equity by 13.7 million, this was a major factor in the decrease of tangible book value per share to 11.86 at December 31, from 12.33 at September 30. Moving on to credit quality metrics, we saw a nice overall improvement in credit quality of the loan portfolio, potential problem loan decreased 13.2 million or 13.1% during Q4. Non-performing loans decreased $631,000 or 5.5% to 0.41% of total loans from 0.45% at the prior quarter end. The ratio for our allowance for loan losses to non-performing loans stands at a very healthy 285%. In addition, included in the carrying value of the loans are $13.5 million of purchase accounting net discounts, which may reduce the needs on allowance loan losses on those related to purchase loans. Net charge off for the quarter was 0.05% of average loans, which lowered the year-to-date charge of ratio to 0.14%. Two OREO properties totaling 754,000 were added during Q4, however due to reductions in non-performing loans our ratio of non-performing assets to total assets remained at 0.30%. Our net interest margin for Q4 was 3.85%. This is a 10-basis point decrease from 3.95% in Q3. Pre-accretion net interest margin decreased 9 basis points to 3.68% for Q4 from 3.77% in Q3. The decrease in pre-accretion net interest margin was mostly due decreases in pre-accretion loan yields as well as decreases in investment portfolio yields. Pre-accretion loan yields decreased partially due to a large loan prepayment penalty realized in Q3 that impacted the quarter's loan yields by 4 basis points. In addition, new loans for Q4 where originated at the weighting average rate of 4.08% which is lower than the weighted average rate of the loan portfolio at the end of the prior quarter. As I commented in earnings release, we continue to increase our floating rate LIBOR based loan segment. The notional amounts of these loans increased to 102 million at year end from 68 million at prior quarter end and from 21 million at December 31, 2015. These launches help improved overall portfolio yield performance in an increasing environment, but they have also contributed toward declining net interest margin in the later part of 2016. Non-interest income decreased $1.7 million from the prior quarter, due mostly to a $2.1 million gain recognized on the sale of a loan during Q3. Of the $1.6 million in loan sale gains recognized in Q4, $1.2 million related to mortgage loan sales gains, $239,000 related to SBA loans sales gains and $190,000 related to other note sales. Non-interest expense for Q4 was $26.8 million which is basically unchanged from Q3 2016 and Q4, 2015. In addition, non-interest expense for year to date 2016 increased to 265,000 or 0.2% from the 2015 amount. The ratio of non-interest expense to average assets continues to improve, this ratio was 2.78% for Q4 compared to 2.81% for Q3 and 2.92% for Q4 2015. Bryan McDonald who will have an update on loan production.

Thanks, Don. I'm going to provide detail on our fourth quarter lending results by production area, starting with our commercial landing group. In the fourth quarter, the commercial teams closed $153 million of new loans, which is down slightly from $159 million closed in the third quarter. For all of 2016 the commercial team closed to $682 million versus 660 million in 2015. Line utilization was 35.6% at the end of the fourth quarter and was relatively unchanged from 35.9% last quarter and 35.7% in the fourth quarter of 2015. Commercial team pipelines ended the fourth quarter at $296.5 million, up from $248.3 million last quarter but down from $336 million in the fourth quarter of 2015. Moving on to interest rates. The average fourth quarter interest rate for new commercial loans was 4.01%, for reference last quarter was 3.66% and in Q2 it was 3.93%. And as Don mentioned the fourth quarter rate for total loans was 4.08%. SBA 7(a) production in the fourth quarter included 17 loans for $14.8 million and the pipeline ended the quarter at $14 million. This compares to the third quarter of 2016 when we closed 8 loans for $2 million and the pipeline ended at $14.8 million. Consumer production during the quarter was $43.7 million, which is in line with each of the prior three quarters. Consumer production for all of 2016 was $171 million, which is a 14% increase over 2015. The mortgage department closed $53.9 million of new loans during the fourth quarter compared to $50.5 million in the third quarter, $43.6 million in the second quarter and, $29.6 in the first quarter of 2016. The mortgage pipeline ended the third quarter at $34.3 million, down from $53.3 million at the end of the third quarter, but up from $29.4 million at the end of 2015. The current pipeline is comprised of 59% refinanced loans, 28% purchased loans and 13% construction loans. This compares to last quarter's pipeline where refinanced business averaged 54%. We continue to place additional emphasis on expanding our customer base in Bellevue and Seattle as part of a King County growth initiative which we started in the middle of last year. At the end of the fourth quarter, our commercial teams in King County had 18 FTEs, including nine commercial bankers. Commercial loan balances associated with the King County commercial team have grown from $145 million at the end of 2014 to $275 million at the end of 2015, to just over $439 million at the end of 2016. And the commercial loan pipeline in King County ended 2016 at $70 million. Deposit relationships managed by the King County commercial team have grown from $66 million at the end of 2015 to $93 million at the end of the 2016. In total, loans and deposits managed by our King County commercial team were $533 million at the end of the 2016, which is a 56% increase over the 2015. The King County market continues to show strong growth prospects, and we will look to selectively add additional bankers as talent becomes available. I will now turn the call back to Brian for an update on capital management, as well as some closing comments.

Thanks, Bryan. I'll start with the capital management. We have continued our regulate quarterly dividend of $0.12 which equates to dividend payout ratio for the quarter of approximately 36% comfortably within our guided 35% to 40% ratio. As Don noted earlier our TCE level drop from 9.9% in Q3 to 9.5% in Q4, primarily due to the changes in our net unrealized losses in our securities portfolio. It is also important to note our Tier 1 leverage ratio which is un-effected by any unrealized losses decreased only 0.2% to 10.3% for Q4 due to increases in average assets and the effect of our special dividend of $0.25 also paid in Q4. We continue to believe our strong capital position sufficiently supports our balance sheet risk, our internal growth and potential future growth both organic and M&A. I'll close this morning by just giving you some of my thoughts for our outlook for 2017. As I reported to you in our Q3 call, we continue to be optimistic about the overall economic economy of the Puget Sound region for 2017 and for our continuing growth. Commercial real-estate construction continues to be robust and we remain disciplined in monitoring our commercial real estate loan production concentration risk. While we remain comfortably under regulatory CRE concentration guidelines that approximately 250% of capital, we're mindful that a higher percentage for our growth this past year has come from CRE and we need to be careful that we maintain discipline over appropriate CRE growth going forward. We’re guiding loan growth for 2017 once again at 6% to 8%. Upside potential will result from lower than expected loan prepayments and down side risk may stem from even more robust commercial real estate concentration risk management disciplines. We will continue to focus on growing core deposits and specifically non-interest bearing deposits over the slightly changed emphasis to maintain current CD balances during 2017. This philosophy stems from our ability to have largely managed out the rate sensitive, single service CD's that we acquired to four FDIC transactions. While year-over-year deposits have grown at a modest 3.9%, our non-interest bearing deposits grew year-over-year at 14.4% and now stands at about 27% of total deposits. We expect non-interest deposits to again grow in the double-digit range in 2017, while our overall deposits should grow in the 4% to 6% range. Due to several large one off non-interest income gains in 2016, such as the $2.1 million gain on a sale of a troubled loan, non-interest income is likely to be flat at best for 2017 over 2016. However, due to some substantial account plan consolidation and account fee structure changes that took place in late 2016, we're anticipating a substantial improvement in service charge account fee income in 2017. Expense management continues to remain a primary focus of the company. We are pleased that our overhead ratio has improved again this quarter to 2.78%. As I mentioned in my comment in the release, this quarter marks the fifth consecutive quarter in a row that our overhead ratio has improved. Your will continue to see some ongoing branch consolidation activities in 2017. As a result of ongoing expense management, we expect in 2017 a few basis points lower in over head the ratio then it currently is. We expect M&A activity in the smaller, less than $1 billion range to increase this year and we expect to be active in that arena. That concludes our prepared remarks. I would welcome any questions you may have and once again refer you to our forward-looking statements in the press release as we answer any questions dealing with the forward-looking comments. Justin, we will open the call to any questions that may be.

[Operator Instructions] Looks as if our first question comes from the line of Matthew Clark, Piper Jaffray. Your line is open.

May be just on the expense guidance, I know you've talked about in the past about keeping that run rate relatively flat at least, though you might be able to keep it, keep the growth flat this year. I haven’t recast the numbers just yet, but an incremental improvement upon that overhead ratio, does that still get you flattish expense growth?

I'll give you some big picture comments and Don will give you more details. And I think that we have been pretty consistent with wanting to get our overall overhead ratio in to that low 2.7 range and I think what we would like to see is on a run rate basis to be into that 2.70 range at year end. Realizing that the overhead ratio is a function of two calculations, one is your expense level, two is your asset growth. If you look back at our balance sheet and you look at our loan growth this past year, we increased our leverage as we pointed out to a loan growth deposits because again we're continuing to manage out some of our higher rate CD's -- higher rate single service CD's, wasn’t as strong as you might have anticipated, but what we really focused on is that non-interest bearing deposit growth of double digits. My whole point here is that, a lot of the loan growth is coming to increase leverage and not necessarily balance sheet asset growth. If we would have a little stronger asset growth of course that overhead ratio would have improved somewhat. So we need to keep in mind that the relationship of those two numbers, but generally we would like to be in that 2.70 on run rate basis by the end of the year. Don?

And kind of how that works out with the math, I think there is going to be a little bit of increase in expenses year-over-year. But we still would like to keep it under a 2% increase overall and under that sum if we can, but we had -- did have some initiatives. We're growing in some markets that are generating income and some initiatives we have going on that are going to probably lead to some additional expenses year-over-year. But again, I think that run rate will continue to improve as we get through the year, but it will -- I think the total non-interest expense for the year will increase some.

Differently said, I think any growth in non-interest expense are going to be related to growth opportunities in the balance sheet.

Right, got it. Okay. And then on the core margin 368, I know that you guys mentioned the increase in LIBOR floaters contributing to some of that pressure on the loan yield, but was there anything else in their linked quarter, with the lower prepayment fees or anything else that puts some downward pressure on the yield there.

Well, we do think and I mentioned that, we have that one large prepayment penalty, I think Q3, that was about 4 basis points in a loan yield. So, I think that was part of it, of the decrease in addition to again, we're putting loans on at an average of 408 beginning of the quarter there were 450 or so. So that's where we're getting through downward pressure just again just the math of putting on loans lower than they started at, so that's a combination.

I will say Matthew that obviously with the growth number that you see in our LIBOR based loans yield year-over-year, represents a very conspicuous effort on our product to layer in more asset -- interest rates sensitive assets. I think will bode well for us going well. So it's a very focused strategy and a conscious strategy on our part given us a little bit of a headwind today on the NIM side. But I think we'll pay dividends as we move forward.

Okay, and then just on your comments around M&A and the extension opportunities you see. Can you just talk about the geography and the things -- the types of your target you might want to consider in terms of I guess you mentioned size being less than a 1 billion but just any update on in terms of activity and criteria of what you might consider?

Sure. When I step back and take a little bigger picture look at this, let's not forget in the last probably 120 days two potential M&A competitors of ours Cascade in Bend and Pacific Continental out of Eugene has both been acquired and they were banks who were active in the Pacific Northwest M&A arena. And I think that the removal of those two competitors, not that there aren’t other competitors, but it's just when you look at competition, whether it's organic growth and we're competing against those folks. So on a day-to-day basis with just organic loan -- organic growth in the marketplace or the potential of M&A. I think that bodes well for us. We are seeing more activity in the M&A markets and discussions that activity tends to be focused and centered with banks in less than 500 million in assets. I don’t know that there is any specific reasoning for that, other than that you can just look at the numbers. There were more banks under 500 million than there are from 500 million to 1 billion. So the population opportunities are greater. But we do see increased activity and potential discussions in that realm, and I'm more optimistic and I have been in a while that we will be active in the M&A game in 2017.

Okay, and then just housekeeping. On the tax rate little bit lighter this quarter, and I'm curious what your thoughts are for an assumption there in 2017.

I think that going forward, I think the tax rate will be probably around what it was for Q4, to be pretty -- it will be between yield of 26 and 27, I'm guessing throughout the year. But in the Q4 it was 26.2, I think that's quite a decent guide for going forward during 2017.

Looks like our next question comes from the line of Jeff Rulis of D.A. Davidson. Your line is open.

Question on the, I guess, the kind of a couple of follow ups on the margin; than the detail on the floating rates impact. But on a core basis as you look into '17, just kind netting out some of the discussion you had. I guess sense for the core firming up is, I know that you talked about new launch coming on at just above four and that's just still a drag, but kind of the balance of the year and what you guys are expecting on that core margin direction?

I think the core margin direction will -- if the rate forecasts are accurate as far as what's going to happen in the overall rate environment, I would expect our core margin to flatten out this year -- by the end of the year. That’s -- and I think we might feel just a little bit of downward pressure beginning the year, but if we have another one or two bumps in the increases as people are predicting, I think we'll flatten out by the end of the year.

And then a little follow up to the deal activity with those institutions, the announcements on Pacific Continental and Cascade, what -- any -- I know its little early but, I guess you are you hearing any inbound calls from sort of talents at those institutions and/or anticipating or looking to get or recruit, any fallout from those acquisitions?

Well Jeff, I guess on a big picture point of view. Anything if there is merger activity in any given market, there is the potential for dislocation in the market. Its way too early to predict or to comment on that, I think most banks would tell you that they're anxious and would love to see that dislocation. I would point back to our or Seattle growth our King County growth. It really hasn't been at dislocation base focus. I think while we do in terms of growing that organic base and lender bases is just through constant contact and discussions with lenders in the market place for a variety of reason, I won't discount this location as an opportunity for us. But if not our primary focus as we move forward in continuing to grow their organic side.

And Brian, that was a little bit of where I was headed than. So is there anything strategic in '17 that as you had built out in Seattle is there another market or the potential for an investment substantially in a region that you could foresee in '17?

We been sharing with our King County result, I think we've been pleased with those results. As I've said several times, the King County results have exceeded our internal expectation, we been very pleased with that. I think we can look at that success story and say can we replicate that elsewhere. That’s a possibility and I think we need to be careful from a competitive point of view that we don’t signal too many things as to what we're intending to do, other than that I would just say, we've been successful there and I will say that we're looking at other opportunities. I may have not given you the detail you were looking for Jeff, but I hope you appreciate the sensitivity of that.

No, I got it that helps. I appreciate the comments.

Looks like our next question comes from the line of Jacque Bohlen of KBW. Your line is open.

Brian, can you provide a little bit of color on what you're anticipating in service charges, what's changing there, what's driving your guidance that there could be a meaningful increase next year, position I guess?

Yes, I'd be happy to, I'm going to ask Jeff to give you a little bit or -- and I think the big picture here, Jacque is, we went to a very big comprehensive account consolidation process starting third quarter last year, culminating late fourth quarter. Jeff, you want to give a little more color on that?

Yeah. Jacque, to put it in perspective, after coming together -- all the banks coming together we found ourselves with something like 20 plus consumer deposit accounts. Too many for our people to stay on top of and confusing for customers in some cases. So we’ve called it the consumer deposit rationalization project, and as Bryan said it was put in play in the fourth quarter reducing our consumer account down to six. And embedded in those accounts make ups there are minimum balances, mostly to drive a conversation -- excuse me, fees for minimum balance and it was mostly to drive a discussion with the customers because we had a lot of grandfathered accounts that are not necessarily active. And then as Bryan pointed to the substantial fee income we expect to get, we’re just seeing the beginning of that late in December. It's hard for us to frame up exactly what that’s going to be because its tied to customer choices and behavior and I think after the first quarter we’ll have a lot better feel for what that’s going to look like for us, but we do believe it's going to have a beneficial impact.

Okay. And are there expense efficiencies tie to this as well given the decrease in account numbers?

To a degree yes, I think that’s less notable than the fee income that we’ll generate from the new accounts.

Okay. And the next question would be on deposit growth. As you look out -- and you’ve commented on double-digit expectation for no-interest bearing balances. Given that we’re in a rising rate environment. Is a lot of that coming from just the growth and King County, as deposits kind of catch up to some of the loan trajectory that you’ve seen and just other new account expectations?

I would advise Brian's comments to this, what makes sense is that that’s really coming across total footprint. It's certainly aided by King County. I think that all of our folks are, retail bankers or commercial bankers have really focused and have been for long time Jacque on the total relationship. And I think that’s focused on -- if you look back -- I mean I don’t have this data in front of me, but I think we’ve been doing this for a last two or three years. So, I think it’s a bit more cross footprint, but Bryan additional thoughts?

I would agree with Brian, it is really broad based and it has been going on for several years, just a number of enhancements, that consumer migration Jeff mentioned had a lot of in favorable enhancements to the customers associated with it. there has been a lot of improvement in terms of the bank's cash management offering. The sales force and then Cindy Huntley and the retail staff along with the commercial staff have just been focused on additional partnering. This time has gone on just looking for more opportunities to work together and bring in the full relationships. So really a broad base of different areas, the bank focused on that and we’re going to continue to do that as we’ve gone into '17.

Okay. And as you think about this growth levels are you also incorporating the potential for additional rate increases into that?

Yes, yes we are.

Okay. Great. Thanks guys. That’s helpful.

Our next question comes from the line of Tim O’Brien with Sandler O’Neill. Your line open. Tim O’Brien: Just baseline here again can you tell me what percentage of your loans are true floating rate loans?

Don's looking through some data here Tim for you, so hang on for just a moment.

Well, here I got some information. For the amount of floating rate that -- like we've said within one year is probably between 600 million and 700 million. And of that about 540 million will just reset, just based off of 25 basis points increase. So the rest of it needs larger increases but I hope that helps you. We have about 300 million type of prime.

So, the rest is try to LIBOR sensibly Don?

Or FHLB, rates or something.

And you added LIBOR based loans during the quarter. Did you already have small book there or is that a new product or?

Yeah. We started -- this is related to the you’ll see the interest rate swap fee income on the non-interest rate income. We started that in, right about, I think September of 2015, and again at the end of last year, I think we got 28 million of these loans and by the end of this year it was 102 million and we added close to 30 million something just in Q4.

And can we assume that’s going to continue? You guys are going to be actively pursuing that kind of business and trying to book those loans?

Tim, this is Brian. We are it’s a really a tool and particularly as we went into the last summer the yield curve was really flat and we were in a really competitive environment. We'd much prefer to take the variable side versus maybe only a 100 basis points more for the 10-year effect. So that was really the strategic approach we were taking. And when we ended last year, as Don just noted, we started the program in late 2015 and had a really good start in the fourth quarter, but not much of the pipeline heading into 2016. 2016 was a strong year, particularly the second half of the year. We are entering into 2017 with a good pipeline. So, yes expect to continue to have this business continue through 2017 and on.

I can, as rates, assuming the rates continue to increase a bit as we go through the year or even if there is a perception of the borrower's behalf that rates are going to increase, I think that bodes well for that activity to continue during 2017.

Here's a dumb question for you Bryan. Are those operating lines, are they tied to something else?

The majority of them are commercial real estate loans.

So, they automatically have kind of full fund -- they’re fully funded?

The majority are fully funded at closing and the bank is taking the variable side of that swap transaction. So, we have a LIBOR based loan on our books and then facilitating a swap for the borrower to achieve an effective fix rate, long-term effective fix rate.

Great. And then last question for Don. Don, do you have or can you share any rate sensitivity analysis. I know data, deposit data can swing a model around, but up 100 basis points for the Fed, can you give us a sense of what kind of benefit that might have on an interest income?

Well I'll say this that, I think in the past we’ve said we were, kind of model out slightly liability sensitive or basically flat. I think we’re still pretty flat, I think we’re with these LIBOR based loans and even on the security side, we’ve been adding more floating rate securities in the security portfolio. So, I think that we’re, I would say slightly asset sensitive. Hard to say again with the curve and everything else how -- what might happen, but I would categorize this as being slightly asset sensitive. So, I would [indiscernible] we will in an upgrade environment going forward.

I would also say that Tim, I think as we look at far data rate assumptions and as we work with our interest rate risk consultants, I think they tend to look at our data, our data on our deposits and say we’re pretty aggressive on the data. So, if that in fact is true, we could be a bit more asset sensitive then maybe we’re thinking we are. Lot of assumptions, as I think and if everyone can appreciate when you get into an interest rate risk model and the sensitivities and you get to the instrument level and you start trying to predict the behavior of the customer and then where rates are going there is just a zillion assumption that go into that. I think as our nature is, we’re pretty conservative on lot of things. So, I'm pretty comfortable, and our balance sheet is more sensitive than we believe it has been, and I think it's probably growing up more asset sensitive as we move forward.

Any chance any of that discussion could make it into your K, Don?

Well, we do put some -- in the K we do put rate sensitivity information in there.

Great, alright. Thanks a lot.

Looks like we do have a follow-up question from the line of Matthew Clark with Piper Jaffray. Your line is open, sir.

Just on -- to get on sale the line item there, it steadily increased the past few quarters. But I'm looking back to the first quarter of last year, we did see a drop, just thinking about the contribution of refi this past quarter. How should we think about maybe that line item going in the first quarter knowing that activity would likely pick up in the springs?

Yes, so the pipelines coming into the end of 2017 stronger than it was at the beginning of last year's. So, I think the first quarter will be definitely higher than last year, where we hit that Q4 average that will depend on how the pipeline does through January and into early February. We still have good purchase activity in the markets. Of course, rates have gone up and some of the refi volume has declined. But we're in a stronger position going into 2017 then we were last year?

Okay, great. Thank you.

And at this point we have no further questions here in queue.

Okay, Justin. I appreciate everyone that called in today. I appreciate your continued interest in our company and this concludes our call today. Thanks again.