Heritage Financial Corporation (HFWA) Q4 2017 Earnings Report, Transcript and Summary

Ladies and gentlemen, thank you for standing by. Welcome to the Fourth Quarter and Year-End 2017 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. [Operator Instructions] And as a reminder, this conference is being recorded. I’d now like to turn the conference over to CEO, Brian Vance. Please go ahead.

Thank you, Linda. Good morning and welcome to all who have called in and also to those who may listen to this in a recorded mode later. Attending with me this morning is Don Hinson, our CFO; Jeff Deuel, President and Chief Operating Officer; and Bryan McDonald, Chief Lending Officer. Our earnings press release went out this morning in a pre-market release, and hopefully, you’ve had an opportunity to review that release prior to this call. And I would ask that you refer to the forward-looking statements in that particular release as we go through our comments this morning, especially during the Q&A session as well. I’ll start off with just some highlights of our fourth quarter and the annual 2017 results. Diluted earnings per common share were $0.23 for Q4 2017, compared to $0.33 for Q4 2016 and $0.35 for linked quarter Q3 2017. Diluted earnings per common share were $1.29 for the year ended December 31, 2017, compared to $1.30 for the year ended December 31, 2016. Total loans net increased $50.9 million, or 1.8% during the quarter. And for the year 2017, net loans increased $207 million, or about 7.9%. Yesterday, the Board of Directors declared a regular cash dividend of $0.15, which is a – which is an increase of 15% from the $0.13 regular cash dividend declared in Q4 2017. Don Hinson will now take a few minutes and go over our financial statement results. Don?

Thanks, Brian. I’ll start with balance sheet. We have total asset growth of $60.3 million in Q4 and assets grew $231 million for all of 2017, which is a 6% increase over prior year end. And this is a strong loan growth mentioned by Brian, total deposits grew $72.2 million in Q4, which outpaced our loan growth for the quarter resulting in slightly lowering our loan to deposit ratio to 84.0% from 84.2% at the prior quarter end. Our credit quality remains stable in Q4. Nonperforming loans decreased to $10.7 million at December 31 from $11.0 million at September 30. The percentage of nonperforming loans to total loans decreased to 0.38% at December 31 from 0.39% at the end of Q3. The ratio of our allowance for loan losses to nonperforming loans stands at a very healthy 300%. In addition, included in the carrying values of the loans are $10.1 million of purchase accounting net discounts, which may reduce the needs of allowance for loan losses on those related purchase loans. We had net charge-offs of $652,000 in Q4 and $3.2 million for all of 2017. Of the $3.2 million charge-offs for the year, $1.7 million related to the closure of two purchased credit impaired loan pools. These charge-offs were related to loan losses that had built up in the pools over the last seven years, but were not recognized as the charge-off until the pool was closed. Our net interest margin for Q4 was 4.02%. This is a 17 basis point increase from 3.85% in Q3 and was due primarily to an increase in discount accretion quarter-over-quarter. Discount accretion increased primarily due to $1.8 million of accretion related to two significant nonperforming purchased loans, which paid in full during Q4. Pre-accretion net interest margin was 3.74% for Q4, which is unchanged from Q3. Pre-accretion loan yields decreased 2 basis points to 4.55% in Q4 from 4.57% in Q3. New loans for Q4 were originated at a weighted average rate of 4.58%, an increase from 4.45% in Q3. The increase in rates on originated loans resulted in upward shifting yield curve from the prior quarter. Cost of funds increased to 37 basis points in Q4 from 36 basis points in Q3. This increase was due primarily to increase in the cost of CDs. Our cost of total deposits for Q4 was 20 basis points, which is unchanged from Q3. Service charges increased 704,000, or 18% from Q4 of 2016, primarily due to deposit account restructuring, which we have previously discussed. Other income increased from the prior quarter due mostly due to $682,000 in net gains on sale of former branch buildings. Our non-interest expense for Q4 was $27.6 million, a decrease of $367,000 from Q3. Included in Q4, non-interest expense was $423,000 of merger-related expenses. Merger-related expenses for the year of 2017 was $810,000. Total non-interest expense to average assets improved to 2.66% in Q4 from 2.76% in Q3 from 2.78% in Q4 2016, and improved from 2.84% for the year 2016 to 2.78% for the year 2017, which is the lowest this ratio has been in any year since the company went public in 1998. Our income tax expense increased in Q4, due primarily to the estimated revaluation of the net deferred tax assets in the amount of $5.6 million, which equate to $0.19 per share. It should be noted that, while we believe that this amount is a reasonable estimate of the impact of the new federal tax legislation, this estimate could be adjusted during the measurement period, which ends in December 2018. Bryan McDonald will now 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 lending group. In the fourth quarter, commercial teams closed $161.2 million of new loans, which is down from $216.6 million closed in the third quarter of 2017 and up from $153 million closed in the fourth quarter of 2016. Commercial team pipelines ended the fourth quarter at $342.5 million, which is up from $312 million at the end of the third quarter and $296.5 million in the fourth quarter of 2016. Line utilization was 34.4% at the end of the fourth quarter, which is down from 36.1% last quarter and 35.6% at the end of 2016. The average fourth quarter interest rate for new commercial loans was 4.57% during the fourth quarter. And as Don mentioned, the average fourth quarter interest rate for total loans was 4.58%. Moving on to our SBA area, 7(a) production in the fourth quarter totaled seven loans for $2.39 million and the pipeline ended the quarter at $11.1 million. This compares to the third quarter of 2017 when we closed eight loans for $6.1 million and the pipeline ended at $14.4 million. Consumer production during the fourth quarter was $51 million, down from $60.7 million in the third quarter of 2017, but up from $43.7 million in the fourth quarter of 2016. The decline in volume quarter-over-quarter was due to a HELOC campaign that drove higher volume during the third quarter. For the full-year, new consumer volume was up 14.8% compared to 2016. The mortgage department closed $35.9 million in new loans during the fourth quarter, compared to $39.8 million of new loans in the third quarter and $53.9 million in the fourth quarter of 2016. The mortgage pipeline ended the fourth quarter at $27.3 million, down from $29.1 million last quarter and $34.3 million in the fourth quarter of 2016. The current pipeline is comprised of 48% refinanced loans, 17% purchased loans and 35% construction loans. This compares to last quarter’s pipeline, where refinanced business averaged 43%. I’ll 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 capital management. Our regular dividend payout ratio for Q4 was 56.5%, which is over our guided 35% to 40% payout ratio due to the impact of the DTA reevaluation that occurred year-end. For the year 2017, our regular payout ratio was 39.5% and with a $0.10 special dividend we paid in Q4, total payout ratio was 47.3% for 2017. As we noted earlier, we increased our regular dividend from $0.13 to $0.15, which is a 15% increase. We continue to believe our capital position sufficiently supports our balance sheet risk, our internal growth and potential future growth, both organic and M&A. I’ll close just with some general observations. We continue to have optimism about the Pacific Northwest economy. We believe our 2018 loan growth will be similar to what it was in 2017. We are pleased with the pace and progress of our Puget Sound Bank integration. As a reminder, we closed this transaction on January 16, and plan for conversion in early May. We’re excited to have Jim Mitchell, former CEO, managing our our combined King County growth strategies for Seattle and Bellevue. We also want again to welcome our new Puget Sound Bank folks to the team and looking forward to their contributions to our continuing King County successes. When the issued shares for Puget Sound Bank acquisitions are recorded on NASDAQ soon. Our reported market cap should be over $1 billion for the first time in our history. We’re particularly pleased with our expense management in Q4 and for the year. And as Don mentioned earlier, our overhead ratio for Q4 was 2.66%, our lowest performance in recent history. Additionally, our efficiency ratio dropped below 60% at $0.597 also for the first time in recent history. We are anticipating our overhead ratio will rise in the first-half of 2018, due to merger-related and infrastructure expenses. But we also expect to work back to current levels by end of the year 2018. While our loan deposit ratio held steady from Q3 to Q4 at about 84%, we continue to believe the retention and growth of high-quality core deposits will be a critical strategy for us and most banks going forward. We will continue to emphasize and focus on deposit growth strategies to maintain our strong liquidity position. We continue to expect M&A activity in banks less than $1 billion in assets and we remain active and interested in additional M&A. 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 the questions dealing with forward-looking comments. Linda, we’ll turn the call back to be opened for questions.

[Operator Instructions] And our first question will come from the line of Jeff Rulis with D.A. Davidson. Please go ahead.

Thanks. Good morning.

Good morning, Jeff.

I wanted to talk about the deposit success a little bit and hoping to get a little color on the Portland market and the team that you have there. And I think, it was indicated that there – they’ve got maybe a better, or not a better, but certainly a deposit focus with that team. Was the makeup of the – if you have the deposit increase by geography if possible?

Yes, I mean, I’ll just provide a few overcome – overview comments and ask Bryan to maybe fill a little detail. We’ve talked about our Portland team the last few calls, and this is both a loan and deposit-generating team. But I think that one of the particular highlights of this team is their focus on high-quality core deposits and they’ve certainly been successful in that regard. We’re a little hesitant to give a lot of specific color, Jeff, for competitive reasons. I will tell you that it continues to exceed our expectations, and I think you can see some of that reflected in our overall deposit growth during the quarter. But maybe ask Bryan to provide some additional comments.

Sure. Jeff, we did see broad-based success with deposit and very strong deposit growth in Portland included in that, maybe just a few comments on the Portland team. We did add an additional four production folks since the end of the third quarter. A couple of those joined the first couple days of 2018. But we’re now up to 11 on the production team, including two support positions. And in general, for Portland, we’ve set a plan out in the middle of 2018 (sic) [2017] when we launched that effort and we’re exceeding our original expectations when we put that plan in place.

Jeff, sorry, we can’t give you additional specific color on that and hope you appreciate the competitive issues there.

No, that’s a good color. Thanks. And then just on the loan side, on the – the C&I balance is being down. It sounds like lower line utilization. But any thoughts on, is there some seasonality or anything going? I mean, the overall growth is solid, and I think you entered the quarter with a lower pipeline than you had the previous quarter and put up a decent number. But maybe just a comment on the C&I outlook maybe for the balance of the year?

Sure, Jeff, this is Bryan, again. We did look closely at that and it was about $20 million drop in outstanding balances. And out of that total, about $12 million was ag-related and then the residual was just pay downs on lines and we continue to have some customers that have significant liquidity and are just using that additional working capital to reduce debts. So we did study that just again didn’t see anything out of the ordinary there just higher liquidity driving that. The pipeline was up quarter-over-quarter. I mentioned the $342 million coming into 2018 that’s up over where we ended last quarter. So we had some growth there. And on top of what we reported, if you add the Puget Sound bank teams pipelines in there, you would add another $40 million takes it over $380 million. So we’re entering Q1 with a really strong pipeline.

And maybe one last one, Don, just the tax rate expected in 2018 effective?

Yes. So as I have previously mentioned, the total rate cut, corporate tax rate cut went from 35.21% that the management thought, because they’re already at around 26% before that. It wasn’t going to drop the all 14 basis points. We’re expecting it to drop probably about 11 basis points going forward. So it would be more in the 15% effective tax rate going forward.

Great. That’s it for me. Thanks.

Thanks, Jeff.

Next, we’ll go to the line of Jacque Bohlen with KBW. Please go ahead.

Hi. Good morning, everyone.

Good morning, Jackie.

Brian, looking to the dividend increase that took place in the quarter, would you categorize that more as based on the strength you had in 2017, or is it a reflection of the lower tax rate you expect going forward?

Jackie, I think, it’s probably both. Certainly reflecting on what I believe was a good solid quarter. And I would say, even the good solid year that that was reflected in that increase. But I think also a nod towards the tax decrease as well.

Okay. And would the Board potentially as you know you get into 2018 and you see the impacts of the tax rate, would you potentially look to increase that dividend once again just as you manage your payout ratios?

We look at that, as you would suspect, Jackie, every quarter, and we have a pretty active capital plan process at the Board level and considering, I think, a variety of things, certainly ongoing profitability growth in the company. I think, our capital levels as it pertains to supporting growth, whether it be organic, or M&A. So there’s a lot of things that fit into it. I think, the short answer is, yes. We would consider it, but we would consider a lot of other things. So there’s opposing forces here that that we’ve got to factor into it. But I guess, rest assured that there’s a pretty active capital management process at the Board level on a quarterly basis.

Okay, definitely understood. And then a question on CD costs just having watched them move up this year and understanding that they’ve had a very limited impact on your overall deposit costs, which have remained quite low. Is that increase that you’ve been receiving, or have you been proactively trying to lock in some money at those rates?

Jackie, this is Don. So we had – we went through some CD specials just to kind of – in the past few years, we’ve seen our CD balances declined some. And so, we did have some more specials this year as far as just holding on to kind of the balances as they were on the CD side. In addition, periodically, we do make rate exceptions as we feel needed. But again, it’s – we’ve seen that. I don’t know if it will happen again this year, we’ll see quite the increase in 2018 we saw in 2017. But we did make a more concerted effort in 2017 to maintain our CD balances.

Okay. And what kind of – I guess, are you receiving an influx of inquiries or has there been any change with the deposit or behavior since the December rate increase?

I don’t think we’ve noticed a whole lot in – on the deposit side as far as a lot – nothing more than we have before the rate increase really. But it’s been – hasn’t been that long also, it’s only been about a month. So we haven’t received that much more we were seeing before the rate increase.

Okay. So we’re not – at this point in time just given where we are, we haven’t really hit that tipping point, where people are taking notice of rate increases from a deposit standpoint?

I just and I’d invite the team to give their color to this as well. I mean, I think, depositors are seeing interest rates increase, rise. I think that they’re taking note of that. I don’t think that we’re seeing a lot of pressure yet. I think that, part of this is going to be on the competitive side in terms of what we see the competitive landscape in this particular region. From my perspective, I don’t see – there’s a few one-offs out there. But I think, it’s pretty limited and I just don’t see much happening there. Does the team see anything different there?

I think, that’s true, Jackie. Most of the regional players are remaining pretty consistent on the deposit pricing and we haven’t seen much change there. As Bryan said, there’s a few outliers that are maybe have more of a funding need and are being more aggressive. But that’s kind of a onesie-twosie rather than the overall market shifting.

Okay. That’s helpful. Thanks, guys. I’ll step back now.

Thanks, Jackie.

Next, we’ll go to the line of Tim O’Brien with Sandler O’Neill & Partners. Please go ahead. Timothy O’Brien: Good morning, guys.

Good morning, Tim. Timothy O’Brien: One question I have is, it’s been quite sometime since you guys published or gave color on sensitivity profile of your balance sheet. Could you give a little – share a little bit of color here at the year-end, maybe to reflect on what changes you’ve tried to make or accomplish to prepare yourself for potential rising rates here over the course of this past year?

Tim, I’ll give a little overview and Don can give you additional color. I guess, we can look at the overall sensitivity of the balance sheet. I know there are lots of discussions in the banking world about deposit betas and that’s real. I think that the reality of is, we’ve seen three or four increases in the last twelve months, now three, I can’t recall them. But our cost of funds has stayed pretty steady. And I think that if you look at models, that might suggest that maybe cost of funds would move a little more than they have because of the rate increases. So I think it gets competitive pressures. I think it gets to a lot of different things. But I think that, I think, we’ve demonstrated the ability to manage interest rate sensitivity maybe on an organic basis as opposed to what the actual models might suggest on sensitivity if that makes any sense. But I’d ask Don to add to that as well.

Yes. Tim, I think that we continue to show that, again, I think, more asset-sensitive than we were maybe a year ago when we probably last – published this in the last K. By the way, it will be out. We will publish it – the information in that – our 10-K, which would be out now by the end of February. So it’s not too far off you’ll have that information. But I think, we are – if you look at last year’s, I think, we’re more asset-sensitive than we were last year and I think we are positively asset-sensitive, but not, again, we’ve always kept kind of on the neutral balance sheet in that way. But I would say that we’re going to improve. I expect our margin to improve this year as rates improve or increase. So that’s, I guess, what I can give you on that. Timothy O’Brien: I guess, one other question for you just a follow on to that, Don. Over the course of the past year, has the proportion of your funded loan that are variable rate tied to prime, say, has that increased? Have you guys been able to grow that relative to fixed rate loans or loans that have a fixed rate component in the past year?

I don’t think we’ve increased it a lot this past year. I think, more of it was done in 2016. I think that Puget Sound Bank coming on will help our asset sensitivity, and the fact they have, I think, more prime-based loans than we had although, it can be obviously a much smaller percentage of our overall loan portfolio. But I think that merger will also help us be more asset-sensitive. But overall, I think, we’re maintaining that piece of it. We’re always looking, I would say, even more, maybe more so on the investment portfolio, we’ve – in the last year, we probably added more variable rates than before. We continue to add to our notional amounts of our swap product that is LIBOR. But I think, again, the increases were more in 2016 than they were in 2017, but we do continue to add to that. Timothy O’Brien: And then last question for you, Don. I thought I caught – you’d mentioned to Jeff that effective tax rate by your calculation coming out of this, the new tax law with the DTA adjustment and everything, 15%, did you say?

For 2018, I’m estimating it to be around 15%. Timothy O’Brien: And that – and the reason that’s below the federal rate is because of tax strategies that you guys have in place?

Correct. Timothy O’Brien: Great.

Just like we were – the federal tax rate was 35% and our effective tax rate was 26% before, so. Timothy O’Brien: So the way the law was written, those strategies are still somewhat effective?

Correct. Timothy O’Brien: Meaningfully effective?

Yes. Timothy O’Brien: Congratulations. That’s it for me, guys. Thanks.

Thank you, Tim.

Next, we’ll go to the line of Matthew Clark with Piper Jaffray. Please go ahead.

Hi, good morning.

Hi, Matthew, how are you doing?

Good, good. On the overhead ratio, the outlook you provided sounds like that includes merger charges. Can you maybe quantify what the merger charges, or maybe you can speak to what you think that ratio might look like if you strip out the kind of nonrecurring stuff?

Well, I think – this is Don, Matthew. I think that we’ve mentioned a couple of things here. We have merger charges. We also have talked about some infrastructure at Puget. I would say merger charges over the next couple of quarters mostly loaded in Q1 will be around $5 million to the Puget Sound Bank merger. So I guess, I’ll let you maybe back into the overhead ratio. But we have some things we are working on. But again, as Brian mentioned that, we expected to be back down to Q4 levels by the end of Q4 2018.

Got it. Okay, great. And then just on the margin, obviously a little volatility in the accretion this quarter. I assume that would normalize going forward. But also thinking about PCBK coming online with that related accretion and their margin profile relative to yours. Also thinking about the impact on taxable equivalent investments with the lower tax rate and what that does to reset your margin. Can you just maybe kind of walk through some of those issues on the core and reported margins?

Yes, we don’t show tax equivalent margin. So we won’t – what we show won’t be affected by the – any taxes that are tied to loans or securities. Talking about the Puget Sound Bank, I think, you mentioned, I think again, they’re a little more asset-sensitive. And I’m sorry, Matthew, I can’t remember what the first.

Yes, sorry, the Puget Sound deal, excuse me. And also the – on the – just on the core, it sounded like you expect a little lift in the core with being a little bit maybe asset-sensitive and the benefit from rising rates here.

Yes.

I guess, that’s still a fair assumption for some gradual improvement?

Yes. So I would expect that.

Okay. All right. That’s it for me. Thank you.

Thanks, Matthew.

Next, we’ll go to the line of Tim Coffey with FIG Partners. Please go ahead.

Thanks.

How are you doing?

Can you talk a little – how are you doing? Can you talk a little bit about the success that Puget has been having? Because I think, the pipeline looks strong. Obviously, the loan balance you supplied in the press release were much bigger than the balances at announcement. So can you kind of talk about what’s going on there? And have your thoughts changed on that performance of the company here?

Yes, Tim, this is Bryan McDonald. The bank has continued to take offensive approach and been active in the market. You can see that in their pipeline going into the first quarter. I don’t have their numbers in front of me here. But they certainly continue to perform well through the rest of 2017. So we’re very optimistic the combination of Puget Sound and our teams in Bellevue and Seattle who had an excellent year last year as well. So again, we’re optimistic based on the quality of the people and where we sit today going into 2018.

Tim, this is Jeff. I think, I would add to what Bryan was – is saying is that, now that we’ve gotten past that change of control date, a lot of the planning process around that is done and there’s a full focus on the market now. So we’re optimistic that the teams are going to work well together under Jim’s leadership.

And perhaps could I read into it that the – your expectations for loan growth for 2018 to be somewhat similar to 2017 is a bit conservative?

Well, there’s a lot of factors, I guess, that go into that comment. We have previously here historically guided 6% to 8%, and what was our growth, 7.9?

7.9.

Yes, 7.9. So it’s – I guess that you could read into that that’s conservative. I’ll let you read into that what you would like. At the same time, Tim, I think that the synergies that we believe that we would create as a result of putting the two banks together, we continue to see those synergies. We continue to be very positive about it. It’s kind of hard to predict. I think actual market forces as we get into this. But from our point of view, we are not any less optimistic about the opportunities today than when we put the two banks together.

Okay. And what other items need to be done or completed to integrate the banks?

So we have conversion scheduled for May. That’s the primary focus right now for the entire combined bank to make sure that we do that in an orderly fashion, but that’s the next big step.

Okay. All right. Well, thank you very much. Those are my questions.

Thanks, Tim.

There are no further questions at this time.

Well, I appreciate, everyone, joining in on our call. Look forward to seeing many of you with investor conferences that are coming up soon and as we move through the year. Thanks for joining us today.