Heritage Oaks Bancorp's (HEOP) CEO Simone Lagomarsino on Q4 2015 Results - Earnings Call Transcript

| About: Heritage Oaks (HEOP)

Heritage Oaks Bancorp (NASDAQ:HEOP)

Q4 2015 Earnings Conference Call

February 02, 2016 11:00 AM EST

Executives

Brain Lace - First Vice President of Heritage Oaks

Simone Lagomarsino - Chief Executive Officer

Rick Arredondo - Chief Banking Officer

Jason Castle - Chief Financial Officer

Bill Schack - Chief Credit Officer

Analysts

Tim O’Brien - Sandler O’Neill

Tim Coffey - FIG Partners

Fred Cannon - KBW

Operator

Good morning, ladies and gentlemen. And welcome to the Heritage Oaks Bancorp Fourth Quarter Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will be provided at that time. [Operator Instructions] As a reminder, this call is being recorded and will be available shortly after the completion of the call on Heritage Oaks Bancorp’s website at www.heritageoaksbancorp.com.

I would now like to introduce your host for today’s conference call, Mr. [Brain Lace], First Vice President of Heritage Oaks. Mr. Lace, you may proceed.

Brain Lace

Good morning. Thank you for joining us today to review our fourth quarter results. Joining us this morning are Simone Lagomarsino, Chief Executive Officer; Rick Arredondo, Chief Banking Officer; Jason Castle, Chief Financial Officer; and Bill Schack, Chief Credit Officer. Our comments today will refer to the financial results included in our earnings announcement released last night. To obtain a copy of this release, please visit our website at www.heritageoaksbancorp.com.

Before we get started, let me remind you that today’s conference call will include some forward-looking statements. These forward-looking statements relate to among other things, current plans, expectations, events and industry trends that affect our Company’s future operating results and financial position. Such statements may involve risks and uncertainties, and future activities and results may differ materially from these expectations.

The speakers on this call claim the protection of the Safe Harbor provisions contained in the Private Securities Litigation Reform Act of 1995. For a more complete discussion of the risks and uncertainties that may cause actual results to differ materially from our forward-looking statements, please refer to our filings with the Securities and Exchange Commission, included in our annual report on Form 10-K for the year ended December 31, 2014, and in particular the information set forth in Item 1A Risk Factors, therein.

Now I will turn the call over to Simone Lagomarsino, Chief Executive Officer of Heritage Oaks Bancorp.

Simone Lagomarsino

Thank you, Brian. Good morning everyone and thank you for joining us today as we discuss our results for the fourth quarter of 2015. We’ll start by sharing some business highlights and then we’ll cover some key accomplishments that we achieved during the quarter. Jason Castle will then provide additional detail regarding our financial performance and an overview of the local economy. We will conclude the call by responding to your questions.

During the fourth quarter, we achieved loan growth of over $40 million or 3.4%, which was spread across several sectors of our loan portfolio. Growth was strongest in the farmland and residential categories of portfolio, which accounted for about 60% of our quarterly loan growth. The remainder was largely due to line utilization by our agribusiness customers concurrent with the beginning of their growing season. We also had growth in commercial and industrial lines and in multi-family loan.

Additionally, we had a few construction projects, which concluded and transferred into commercial real estate during the quarter as well. New loan originations were 112% for the quarter, which was the highest quarterly production achieved in 2015. Our loan pipeline remained strong at this time and we expect that originations from the pipeline will drive loan growth during the first quarter of 2016 at our quarterly target of 2.5% to 3%.

We had $55 million of loan payoffs during the quarter. Although fourth quarter payoffs were elevated compared to average quarterly payoff rates in 2014 and 2015, we do anticipate that payoff will decline going forward due to the combined impact of a decline in both refinance activity and credit related run-off and our new swap product, which will allow us to offer additional longer term fixed rate lending capacity without incurring interest rate risk.

We anticipate that quarterly loan payoff levels will decline to somewhere between $35 million and $40 million per quarter in 2016. We have also very recently booked our first customer interest rate swap and we have a couple of additional swaps in our pipeline that will contribute to non-interest income growth during the first quarter. We expect our customer’s interest in this product will increase particularly if we experience a rising rate environment.

As we discussed last quarter, we typically experienced a cyclical decline in our deposits during the fourth quarter attributable to year-end planning issues in the beginning of the agricultural growing season. Deposits contracted slightly during the fourth quarter by $6.8 million or less than a half of a percent. We experienced a shift in our deposit mix out of non-interest bearing demand deposits and time deposit into money market and interest bearing transaction account.

The decline in our non-interest bearing demand deposits during the fourth quarter was largely attributable to three reasons. Number one, year-end distribution; number two, tax planning expenditures; and number three, operating expenditures by some of our agribusiness clients due to the beginning of their growing season. Annual deposit growth for 2015 was strong at 12.2% and we continue to anticipate double digit annual deposit growth during 2016.

However, due to the cyclical nature of our agribusiness plan, we anticipate continued cash utilization during the first quarter of 2016, which will impact our deposit balances. We also typically experienced some reductions in our deposit during the first quarter due to tax planning and annual distribution. The combination of thee cyclical activities could result either modest deposit growth or modest deposit contraction during the first quarter of 2016.

Our net interest margin expanded by 9 basis points to 3.67% for the fourth quarter of 2015, compared with 3.58% for the prior quarter. The increase in our margin as compared to the prior quarter was due to the changes in the composition of our earning assets. The percentage of both average loans and average investment securities to average earning assets increased and average interest earning deposits and other banks declined, which supported net interested margin expansion despite a slight decrease in our loan yields.

Loan yields declined by 3 basis points to 4.92% from 4.95% from the prior quarter. However fourth quarter loan yields were supported by non-recurring items attributable to loan prepayment, which contributed an additional 8 basis points to loan yields and 5 basis points to our margin this quarter compared to the prior quarter. Our net interest margin continues to be impacted by the decline in loan yield due to the origination of loans at lower rates than the rate on loans paid-off. During the fourth quarter, the yield on new loan originations averaged 4.09%, while loan payoffs averaged 4.81%.

We expect to continue to see downward pressure on our net interest margin attributable to the low long-term rate environment. However, we expect that both the recent increase in short-term rate and anticipated loan growth will work to mitigate these issues and continue to support a net interest margin in the range of 3.5% to 3.6% for the first quarter of 2016.

Let’s now turn to the financial performance. Net income available to common shareholders decreased by 500,000 to $3.5 million or $0.10 per diluted common share, compared to the linked quarter. Net income declined during the fourth quarter despite a $700,000 increase in net interest income. The decline in net income was attributable to a 700,000 decrease in non-interest income and a 600,000 increase in non-interest expense, compared to the linked quarter. Jason will discuss the details of these variances in a few minute.

Credit quality remained relatively stable during the quarter and we had another quarterly decline in non-performing assets as a percent of total assets, to the lowest quarter end level we’ve reached in the past several years. We’ve also analyzed our exposure to oil and gas producers given the turmoil in the energy market and determine that our direct exposure to that market is less than a tenth of a percent of our total loan portfolio.

We continue to monitor the drought conditions in the California central coast region and to date we haven’t seen any deterioration in any of our agribusiness credit nor have we had any drought related losses materialize at this point. We have however provided $1.8 million or 10.3% of our total $17.5 million of allowance for loan and lease losses for possible drought related losses. This equates to roughly 14 basis points of our total growth loan.

In addition, we performed property inspections of all agribusiness loans between $0.5 million and $2 million and third-party inspections for all of our agribusiness loans in excess of $2 million, which include verification of water resource availability. The return on average asset was 73 basis points and the return on average tangible common equity was 7.77% for the fourth quarter and 85 basis points and 8.83% for the year.

We are pleased to announce a $0.06 per share dividend, which represents a 3.2% annualized yield based on our closing market price as of February 1, 2016 and a 59% payout ratio based on fourth quarter earnings. The dividend will be paid on February 29 to common shareholders of record as of February 17. This dividend is further testament to the strength of our core banking activities and our confidence in our financial performance going forward. We are focused on optimizing our capital levels and improving our overall return to our shareholders.

Now Jason will discuss additional details about our financial performance and he will conclude with an overview of local economic trends.

Jason Castle

Thank you, Simone. During the fourth quarter, net interest income increased by $700,000. This increase was driven by average balance growth in both loans and investment securities as well as non-recurring income related to loan prepayment activity. Much of our loan production for the fourth quarter came into the quarter.

At December 31, 2015, our total loans held for investment were $1.247 billion compared to our fourth quarter average loan balance of $1.221 billion, or approximately $25 million lower than the balance at year-end. The increase in loan interest income attributable to the year-end production will be realized during the first quarter of 2016. We anticipate that loan production will remain strong supporting further net interest income growth during the first quarter of 2016.

Non-interest income was $2.1 million for the fourth quarter and decreased by $745,000 compared to the prior quarter. The decrease in non-interest income was largely attributable to asset liability management actions executed in the prior quarter. The decline in non-interest income during the fourth quarter was attributable to non-recurring items recorded in the prior quarter including a $600,000 gain on debt extinguishment and approximately $100,000 of gains on the sale of investment securities.

We also experienced a decline in mortgage banking revenues of $70,000 during the fourth quarter, compared to the linked quarter with the implementation of the new TILA-RESPA Integrated Disclosures, which slowed down the operational processes at some of our investors. This was a temporary issue and these delayed gains will be reflected in our first quarter 2016 earnings.

The combined impact of our new interest rate swap offering delayed mortgage gains from the fourth quarter and increases in other categories as non-interest income as anticipated results of $300,000 to $400,000 with additional non-interest income for the first quarter of 2016.

Non-interest expense increased $623,000 during the fourth quarter as compared to the linked quarter. Due to the higher salaries and benefit costs, which rose $6.2 million for the fourth quarter from $5.6 million during the third quarter as well as an increase in professional services of $200,000.

The increase in salaries and benefit costs was due to additional SG [ph], mortgage commission expense and other compensation expense items. Full time equivalent employees were 283 as of December 31, 2015; 271 as of September 30,2015; and 294 at December 31, 2014. The increase in SG [ph] over the last quarter was driven by new hires to fill open positions, the majority of which were customer facing staff.

Mortgage commission expenses attributable to increase production, however, we did not receive a propionate increase in mortgage gains on sale during the fourth quarter due to the previously discussed TILA-RESPA Integrated Disclosure implementation.

Professional services remained elevated during the fourth quarter due to our BSA remediation efforts. During the fourth quarter, professional services increased by $2.4 million from $2.2 million in the linked quarter. This increase was driven by a $400,000 increase in BSA related costs, including consulting and special audit costs.

When we finalized our remediation efforts and anticipate this BSA related costs will decline substantially to the $1 million range in the fourth quarter to a normalized level in $100,000 range. We expect that professional service expense will decline somewhat during the first quarter of 2016, however, we will not see the full decline we have indicated previously until we have remediated issues identified in the BSA Consent Order.

We expect that non-interest expense will decline by approximately $300,000 for the first part of 2016 compared to the fourth quarter of 2015. The decline is primarily attributable to an expected reduction in professional service expense, which will more than offset anticipated increases and salaries and benefits costs attributable to filling open position, seasonal effects such as the resumption of payroll taxable for some employees.

Income tax expense declined by $117,000 or 5.7% during the fourth quarter compared to the prior quarter, while pre-tax income declined by 10.6%. The company’s effective tax rate for the full year 2015 was 36.7%.

The bank exceeds the regulatory capital ratios required to general be considered well capitalized. The economic indicators in accountings we operate in were generally positive. The trend in unemployment rates as of November 2015 comparatively less to August 2015 across the tri counties.

In San Luis Obispo County, the unemployment rate decreased to 4.4% from 4.7%. Santa Barbara County showed another increase to 5.1% in November from 4.8% in August and was 4.6% in May 2015. Ventura County declined to 5.4% from the previous 5.8%. All are still below California’s unemployment rate of 5.7%, which also declined from 6.1% in August. The median home value as of year-end 2015 showed a year-over-year increase in all three counties.

San Luis Obispo County increased by 7.5%, while Santa Barbara County increased by 3.8% and Ventura county increased by 6.4% during the year. The trend for commercial vacancy rates for San Luis Obispo County in the fourth quarter of 2015 grew with Northern San Luis Obispo County showing industrial rates of 1.1%, retail of 2.8% and office at 7.5%; southern San Luis Obispo County had an industrial vacancy rate of 2.3%, retail 1.3% and office at 5.3%.

Santa Barbara County’s commercial vacancy rates declined slightly in the fourth quarter to 3.3% to 3.4% earlier in the year, reflecting a very high level of demand for commercial space in our market. Ventura County had a year-over-year decrease in commercial vacancy rates from 5.3% in the fourth quarter of 2014 to 4.3% for the fourth quarter of 2015.

I will now turn the call back over to Simone.

Simone Lagomarsino

Thank you, Jason. This quarter, we excluded the page in our press release containing the detail regarding our loans and deposits and we’ve had several linked quarters already about that information and therefore we will be filing tomorrow in an 8-K along with an investor presentation. Those two schedlues and we will certainly include that going forward in our future earnings releases.

I’d now like to provide an update related to the BSA Consent Order that we entered into with our regulators in November of 2014. As we have reported in the past, order is entirely related to Bank Secrecy Act and Anti-Money Laundering compliance. Though we’ve made significant progress in our BSA program, we will still have some additional remediation work to do in order to achieve full compliance with the BSA Consent Order. We will remain focused on this goal until the issues identified are fully remediated and the BSA Consent Order is lifted.

We are focused on growing our relationship banking business and capitalizing on our plan to capture additional market share in 2016. We firmly believe that we have positioned our company to be the community bank on the central coast further enhancing our franchisee and shareholder value.

And at this point, we will now open the lines for questions. Operator, will you please explain the process.

Question-and-Answer Session

Operator

[Operator Instructions] And the first question is from Tim O’Brien of Sandler O’Neill. Your line is open.

Tim O’Brien

Good morning.

Simone Lagomarsino

Good morning, Tim.

Tim O’Brien

Could you give a little bit of, just the break-down of beginning balances, end of period loans and so we’ve got the origination volume, how much was, what was the volume on draws, the net growth in utilization draws or line usage?

Simone Lagomarsino

So, let me first give you kind of what you asked for in the beginning and then I’ll have Jason and Rick fill in from there. So, you asked kind of where the balances ended up and I mentioned that our residential one to four family portfolio increased by 11 million, farmland increased by about 13 million, multi-family residential increased by about 4 million, commercial and industrial increased by about 5 million and our agriculture increased by about 17 million. And we saw a reduction in construction and land as we moved to projects that was completed into our commercial and that was about 5.5 million. And with that I’ll let Jason talk a little bit about the advances that we had about 28 million in advances, do you want to break that down between ag and, [indiscernible]?

Jason Castle

Yeah. So, line utilization across all categories of loans was 20 - in round numbers it was about 28.5 million and the portion of that was, which was both for agriculture operating lines, for farmland revolvers was about 23 million of net line utilization. And I can give you the totals for the whole loan book for the quarter. We had new originations around 81 million. The net line utilization around 20.5 million, payoffs is about little north of 55 million and amortizing payments right around 14 million. That will roll you from gross loans at 9.30, 1.206 billion to the balance at the end of the year at a 1.246 billion. That is not including the [indiscernible].

Tim O’Brien

So, what C&I utilization on a dollar basis up in the quarter, I think you said that, right?

Simone Lagomarsino

Yes.

Jason Castle

Yes, it was. Absolutely. I mean…

Simone Lagomarsino

11 million.

Jason Castle

Yeah.

Tim O’Brien

11 million. And then did you say that - and construction utilization was down?

Jason Castle

No. Construction utilization is actually up, what we had happen was transfer a construction loan out of the construction category into a permanent financing.

Simone Lagomarsino

So, balances were actually down, but percentage utilization was flat.

Jason Castle

But the line utilization [indiscernible] yes.

Tim O’Brien

So, what was the decline in absolute dollar balances of construction? That I guess it will net out to the 28 million when I just factor in the C&I and ag correct?

Jason Castle

In the construction and land category, the decline was about …

Simone Lagomarsino

5.5, 6 million.

Jason Castle

Yeah, 6 million.

Simone Lagomarsino

Went from 42.5 to 35.7.

Tim O’Brien

Great, that’s great color. Thank you. And what about new loans, new unfunded commitments, did you, could you talk a little bit about that for each of those categories, did you guys book new commitments in the quarter that didn’t fund yet either in ag production or C&I, or both?

Rick Arredondo

Well the short answer, this is Rick, yes, with our focus on C&I business we have a lot of lines that we basically put on our books that will be utilized periodically throughout the year and we will see those draws up and down throughout the quarters. So, yes definitely a focus for us.

Tim O’Brien

And what was the total one-time dollar amount of contribution to the margin either through accelerated accretion or pre-payments, or both?

Jason Castle

The total amount of additional basis points to the net interest margin was 7 basis points for accelerated and - accelerated prepayments as well as prepayment fees, the increase quarter-over-quarter was 5 basis points, so we had 2 basis points in there in Q3, 7 and Q4, and the schedule accretion, and the scheduled amount was about 9 basis points in both quarters.

Tim O’Brien

And then last question, as far as additional compliance work to do for BSA, Simone could you, obviously this agreement has been in place with the regulators for some time now and you guys have worked long and hard at it, allocated a lot of resources, human resources time, money, everything added, what’s left - what kind of work is left to do, what is that work exactly? So, far along in this process like that, is it related like time and performance or are you guys being measured on a, you know over a period of time or what exactly is that, what can you tell us there of anything? I understand if you can’t talk about it, but it would be great if you …

Simone Lagomarsino

I will gladly address that. So, let me maybe first start by saying that that we have spent a significant amount of money working to make sure that we are ready for our next exam. This last quarter we had a validation of our system that we completed which cost us somewhere around 160,000, is that right Jason?

Jason Castle

Yes, that’s right.

Simone Lagomarsino

And we had two audits last year, one was full audit, one was a review of the results of the audit, all really to help us continue to work to prepare for the upcoming exam. Our real emphasis and focus is to be ready and at a point in our next exam to have that BSA order lifted. And so when you ask what’s left, we feel that we’ve made a huge amount of progress, we do understand that the regulators want to see - demonstrate that it’s been in place for a while, so it is not just that they can come in and see that we haven’t done now, but they want to be able to see that that we’ve had it in place for a while and I think we feel that they will be able to see that when they come back in for our [indiscernible].

Tim O’Brien

And beyond that do you regularly dialogue with them or are they kind of, they are probably in the loop on this process all along, but then the examination will be kind of the formal review of it? Or are they kind of out of the loop and you guys are, you know what your marching orders are and do you communicate…

Simone Lagomarsino

We clearly we can’t have discussions about what our - what our discussions are with our regulators, but you can see from the consigned order, which is public that we are communicating with them on a quarterly basis and so, yes, we do have ongoing communications with them so they are tracking to our progress.

Tim O’Brien

Alright, thanks a lot for the color.

Simone Lagomarsino

Absolutely, thanks Tim.

Operator

Thank you. The next question is from Tim Coffey of FIG Partners. Your line is open.

Tim Coffey

Thank you, good morning everybody.

Simone Lagomarsino

Good morning, Tim.

Tim Coffey

To kind of follow-on O'Brien’s questions, the exit of the money service businesses during the year, what was the reduction in revenue associated with those lines on an annual basis?

Simone Lagomarsino

$500,000.

Tim Coffey

Okay. Do you have any opportunities or plans to expand and generate the equivalent amount of revenue going forward?

Simone Lagomarsino

Well, we’ve rolled out our swap product. We actually have sold a swap already this month in January and that’s certainly one program that we believe could actually help replace the $500,000 in lost revenue from the money service businesses.

Tim Coffey

Okay. And then when is the next exam?

Simone Lagomarsino

I can tell you that our last one was in June of last year, so I would expect the next one to be somewhere 10, 12, 14 months from now. We don’t always know the exact time of that.

Tim Coffey

Okay. That’s helpful. And then, I heard you correctly when you said exiting the BSA Consent Order would reduce BSA related cost back down to the $160,000?

Simone Lagomarsino

About $100,000 in the quarter from what we spent in the last quarter was $1 million. So we expect that going forward it would be $100,000 a quarter as opposed to the $1 million in the fourth quarter.

Tim Coffey

Okay. And then on the loan portfolio, where are you originating new loans right now on a yield perspective?

Simone Lagomarsino

Average yields were about 4.09 for the loans that we booked.

Tim Coffey

Okay. All right. Well, thanks those are my questions.

Simone Lagomarsino

Thanks, Tim.

Operator

Thank you. [Operator Instructions] The next question is from Fred Cannon of KBW. Your line is open.

Fred Cannon

Hi, thanks for taking my question.

Simone Lagomarsino

Absolutely.

Fred Cannon

I just wanted to follow-up on the swap program. I was wondering if you could give us a little more detail first of all kind of how expensive you think that could be to your clients? And then number two, how you expect that to affect your own balance sheet income statement in different interest rate environment?

Rick Arredond

This is Rick Arredond. We and our markets compete with pretty much all the major banks and so that’s been a very important product for us to remain competitive since – obviously there is a lot of desire for fixed rate loans. And we feel that the clients in our markets have some experience with swaps. So we are very encouraged by the initial reaction to the interest in the swap program and our ability to deliver – really a very experienced third-party vendor. So they bring a lot of expertise to the table and we’ve already booked our first loan and we expect two or three more in the first quarter.

Simone Lagomarsino

And Jason can talk a little bit about the income that we anticipate earning from that.

Jason Castle

Yes, going forward, we – for 2016 at least we expect that the swap income should generate about $200,000 in additional non-interest income per quarter and I just want to say too that the swap card really one of the added benefits is that it allows us to have another tool to manage interest rate risks. So we are looking at that as well as interest rate risk management tool.

Fred Cannon

So the $200,000, is that the straight fee that you earned from sourcing the swap to your third-party?

Jason Castle

That’s correct. That’s correct.

Fred Cannon

And then, I guess, since you are just sourcing the swap out in terms of managing your own interest rate sensitivity, what this is just doing is allowing you to have more variable rate loans on your balance sheet is that what you are implying there?

Jason Castle

That’s correct.

Fred Cannon

Okay. Okay, great. And then just one follow-up. I know you’ve answered a lot of questions on the loan book. Is there a sense for how much of the loan growth in the quarter especially related to the farm, the ag sector is seasonal related rather than kind of ongoing trend rate related?

Simone Lagomarsino

Well, we do see a real cyclical effect of usage of our agri business lines and we had about 80 million in advances in those agribusiness lines as they are funding the growing season, the beginning of the growing season. But farmland and some of the other loans that we made are not seasonal, they are going to loans that will be in place through the term of loan.

Jason Castle

And we also will have a bit more going forward in the construction category. So just to the effect of the buildout of the product – the effect of the buildout and then the permanent financing will create these volatility and [indiscernible] obviously.

Rick Arredond

And just to add some color to that, these are what I would consider more C&I customers were actually taking this business from the competition. So it’s really more permanent business for us, which includes C&I financing, farmland and line of credit.

Fred Cannon

All right, okay. Are you picking up that business from other banks or is this from the farm credit groups?

Rick Arredond

I would say primarily it is from the banking sector that’s been kind of our focus.

Fred Cannon

Okay, okay. Thanks so much. Very helpful.

Jason Castle

Appreciate the time.

Simone Lagomarsino

Thank you, Fred.

Operator

Thank you. [Operator Instructions] We have a follow-up question from Tim O’Brien of Sandler O’Neill. Your line is open.

Tim O’Brien

Just real quickly on the structure of the ag land loans, can you give a little detail on cash equity and loan to value and also pricing of real estate and how you are managing that from credit standpoint?

Simone Lagomarsino

Sure. Bill Schack, our Chief Credit Officer will answer that one for you.

Bill Schack

Hi, our maximum loan to value for our farmland is 75%, we typically don’t see things go quite that high. The ones that we did this quarter range generally from 70% to 60% and that’s fairly typical for us.

Tim O’Brien

Thanks a lot.

Operator

Thank you. There are no further questions in queue at this time. I will turn the call back over for any closing remarks.

Simone Lagomarsino

Thank you all very much for participating. This concludes the heritage oaks fourth quarter of 2015 investor conference call. Thank you.

Operator

Thank you. Ladies and gentlemen, you may now disconnect at this time. Good day.

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