Heritage Financial's (HFWA) CEO Brian Vance on Q1 2016 Results - Earnings Call Transcript

| About: Heritage Financial (HFWA)

Heritage Financial Corporation (NASDAQ:HFWA)

Q1 2016 Earnings Conference Call

April 21, 2016 2:00 PM ET

Executives

Brian Vance - President & CEO

Donald Hinson - EVP & CFO

Bryan McDonald - EVP & CLO

Jeffrey Deuel - President & COO

Analysts

Matthew Clark - Piper Jaffray

Tim O'Brien - Sandler O'Neill

Riley Stormont - D.A. Davidson

Jackie Chimera - KBW

Operator

Ladies and gentlemen, thank you for standing by and welcome to the Heritage Financial Earnings Conference Call. At this time, all participant lines are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would like to now turn the conference over to your host, CEO, Brian Vance. Please go ahead.

Brian Vance

Thank you, Selena. I'd like to welcome all who have called in for our first quarter earnings conference call, and those who may call in later on a recorded mode. Attending with me is Don Hinson, our CFO; Jeff Deuel, who is the President and COO; and Bryan McDonald, who is our Chief Lending Officer and he is attending remotely with us today.

Our earnings press release went out this morning on a pre-market release and hopefully you've had an opportunity to review the release prior to this call. I remind everyone to refer to our forward-looking statements contained in that recent press release.

I'll start with the highlights of our first quarter results. Diluted earnings per common share were $0.30 for the quarter ended March 31, 2106 compared to $0.32 for the quarter ended March 31, 2015 and $0.32 for the linked quarter ended 12/31/15. Heritage declared a regular cash dividend of $0.12 per common share on April 20, 2016, an increase of 9.1% from $0.11 for the cash dividend paid in the quarter ended March 31, 2016.

Return on average assets was 1% and return on average tangible common equity was 10.48% for the quarter ended March 31. Total loans receivables net increased $57.2 million or 2.4% to $2.43 billion at March 31, 2016 from $2.37 billion at December 31, 2015. Don Hinson will take a few minutes and cover our financial statement and results. Don?

Donald Hinson

Thanks, Brian. I will start with the balance sheet. As Brian mentioned, net loans grew $57 million during Q1. Much of this growth occurred late in the quarter, therefore we will experience a nice benefit from this in Q2. As a result of loan growth, our loan to deposit ratio increased to 77.8% from 76.6% at yearend. Investment balances increased $10 million to $822 million at March 31, due mostly to an increase in under realized gain on the portfolio.

During the quarter the percentage of demand deposits to total deposits increased to 25.4% from 24.8% at the prior quarter end, and total non-maturity deposits to total deposits increased to 87.0% from 86.5% from the prior quarter end. We continue to experience a runoff in CD balances due to lower rate in the environment.

Moving on to some credit quality metric. We continue to see overall improvement in the levels of potential problem loans. Potential problem loans decreased $15.5 million or 14% during Q1. Non-performing assets to total assets increased to 0.39% as of March 31 from 0.32% as of December 31. Much of the increase was a result of three problem loans totaling $2.5 million that we placed on non-accrual during the quarter. All these loans are secured with commercial real estate and are properly reserved for. The borrowers operate in different industries so we did not see the increase in non-performing loans as a trend. The ratio of our allowance below loses to non-performing loans still stands at a very healthy 240%.

In addition included in the carrying value loans, $18.6 million of purchased accounting net discounts which may reduce the need of allowance below loses on those related purchase loans.

Our net interest margin for Q1 was 4.04%. This is a seven basis point increase from 3.97% in Q4. Pre-accretion net interest margin increased 13 basis points to 3.82% for Q1 from 3.69% in Q4. This increase was due to a combination of increased yields in the loan and investment portfolios, as well as additional leveraging of the overnight cash positions during the quarter.

Non-interest income decreased $508,000 from the prior quarter, due mostly to the final gain recognized in Q4 on the sale of the Merchant Visa portfolio. Off the gain of sales loans in Q1, $598,000 relate to mortgage loan sales and $131,000 related to SBA loan sales.

Non-interest expense for Q1 decreased $400,000 from the prior quarter. The decrease was due mostly to a decrease in $450,000 in occupancy and equipment expense. This was due primarily to the effect of branch consolidations. Most of the decrease is due to approximately $300,000 across which occurred in Q4 2015 as related to the branch consolidation process.

I'll now pass it off the Bryan McDonald who now have an update on loan production.

Bryan McDonald

Thanks, Don. Good morning everyone, and I'm going to cover the production activity during the quarter for each of our primary lending areas starting with commercial banking.

During the first quarter, the commercial teams closed $151 million of new loans which is up from the $149 million closed in the fourth quarter of 2015 and $131.6 million closed in the first quarter of 2015. Gross loan total increased during the quarter by $57 million as a result of the strong level of originations, more loans funding at closing and lower pay up activity than we encountered in the fourth quarter of 2015.

Commercial team pipelines ended the fourth quarter at $310.3 million down from $336 million at the end of 2015. Loan demand has remained consistent from our customer base and our calling efforts continue to provide the bank a number of new opportunities. Line utilization at the end of the quarter was 34.6%, this equates to $139 million of outstanding's on $403 million of commitments and compares to 35.7% for the fourth quarter of 2015. The utilization percentage of the last two quarters is down from the 38% to 39% range which has been more typical the last two years. The average first quarter interest rate for new commercial loans was 4.15%.

Moving on the SBA. We had 10 loans closed in the first quarter for $2.4 million and the pipeline ended the quarter at $12.8 million. This compares to the fourth quarter of 2015 when we closed four loans for $2.6 million and the pipeline of 7A loans ended at $9 million.

Consumer production during the quarter was $42.8 million. This is in line with the prior quarter with branch consumer lending making up a larger portion of the volume as a result of the consumer platform being rolled out across the Heritage Bank footprint after the Whidbey Island Bank merger.

Branch consumer volume had average $14.2 million per quarter in the past three quarters as compared to $7.8 million per quarter in the same period after the merger. This is an 82% increase in branch consumer loan volume and the proportion of branch volume to total consumer loan volume has also increased from 26% to 35% over the same period.

The mortgage department closed $29.6 million in new loans during the first quarter compared to $29.4 million in the fourth quarter of 2015. The mortgage pipeline ended the first quarter at $41.1 million up from $29.4 million at the end of 2015. Current pipeline is comprised of 50% refinance loans, 37% purchase loans and 13% construction loans. This compares to last quarter's pipeline where refinance business averaged 56%.

I'll now turn the call to Jeff Deuel who will have an update on our retail strategy.

Jeffrey Deuel

Thank you, Bryan. On the last earnings call, I highlighted our continued focus on transforming our retail presence and outlined the six-branch consolidations scheduled for the first quarter of 2016. We're beginning to see evidence of these efforts in the form of reduced expenses as well as improved deposits per branch. As a result of our effort to implement process improvement and identify efficiencies, we're also seeing a positive effect on non-interest expense in general. We have also been working on system improvements and product enhancements to provide a better experience for our customers.

We introduced the following enhancements, the first is CardValet which is a mobile app that enables cardholders to manage their debit card with the ability to turn a card on, off, set general spending limits and create activity alerts, and also a person to person services that allows online banking users to send secure electronic payments. Anyone with a U.S. bank account, payments can be sent to a bank account, a mobile phone number or an e-mail address. We can also accommodate external transfers between owned accounts and other financial institutions.

In the next few months we will activate several other product enhancements including consumer online banking entitlements which allows the customer to create sub-users on their account for a variety of purposes. EMV for the debit cards for greater security, business mobile banking which will allow our business customers to use our business online banking product to view balances, transfers, ACH and wires, and instant issue debit cards which will enable newer replacement cards to be generated on the spot in the branches. All of these enhancements will make it easier for our customers to manage their accounts, but it also provides the bank with more options for creating retail efficiencies and reducing expenses across our footprint.

I'll now pass it on to Brian for an update in capital strategies and closing comments.

Brian Vance

Thanks, Jeff, and I'll start with capital management. As mentioned previously we have increased our regular cash dividend to $0.12 from $0.11. Our tangible common equity increased to 9.9% from 9.7% at the end of Q4, and our strong tangible common equity levels continue to give us flexibility for a variety of growth opportunities as well as capital management strategies.

Additionally, during Q1 we bought back 100,000 shares under our repurchase plan at an average price of $17.08 which was roughly 1.5 times tangible book value. Some comments now on the outlook for the balance of 2016. We continue to be optimistic about the overall economy of the Puget Sound Region. Real estate values across all sectors continue to appreciate and most all economic indicators continue to show major ball improvement.

Commercial real estate construction growth is robust in the region and construction activities seems to match demand at this point, but we are being careful to constantly monitor and limit loan concentration in high activity sectors. Managing our concentration levels may cause us to turn away certain loan origination opportunities consistent with establishing and maintaining discipline over our loan concentrations.

As I previously stated, loan growth is not always perfectly linear. As stated earlier, the annualized loan growth for Q1 was 9.6%. Previous quarters have ranged from flat to double-digit annualized growth. Our year-over-year loan growth was 7.5% which is on the higher side of our guided 6% to 8% growth. We continue to be optimistic. Our net loan growth for 2016 will be in the 6% to 8% guidance that we have been giving.

While overall loan quality remain strong, we continue to improve it. On a linked quarter basis, our loan quality as majored by the sum of total non-performing assets, restructured performing loans and potential problem loans improved 8.7%. Q1's annualized performance is even an improvement to the same loan quality measurements for the years 2016 over '15 which was 22%.

While total deposit growth was modest in Q1, our non-interest deposit growth was 3% or 12% annualized. We have guided our annual non-interest deposit growth at 8% to 10% and are pleased at this important category continues to improve nicely.

I am pleased that we continue to improve our overhead ratio as we have guided for the past several quarters. Our overhead ratio for 2015 was 3.01%, a significant improvement over 2014's overhead ratio of 3.49%. Our overhead ratio for Q1 improved at 2.91%, substantially better than Q1 of '15 at 3.07% and also an improvement from Q4 overhead ratio of 2.92%.

Additionally, it is important to remember this non-interest expense improvement has been accomplished while adding significant new expense for our Seattle office.

We continue to guide to an overhead ratio of approximately 2.85% on a run rate basis by the end of this year. That concluded our prepared remarks and I'd welcome any questions you may have, and once again would refer to our forward-looking statements in our press release as we answer any of these questions that you may have.

So that completes our prepared remarks and we would open it for any questions that they may have.

Question-and-Answer Session

Operator

[Operator Instructions]. One moment, Mr. Vance, for the first question. And our first question comes from the line of Matthew Clark with Piper Jaffray.

Matthew Clark

Good morning guys.

Brian Vance

Hi, Matthew.

Matthew Clark

Hey good morning guys. First one some new loan pricing, just wanted to get an update on what the weighted average rate was on the new loans this quarter?

Brian Vance

I think it was 4.15% for new loans during the quarter.

Matthew Clark

Okay. Great and tax rate, you know bouncing around a little bit here the last few quarters, just curious what your expectations are for the balance of the year?

Brian Vance

Yes, I think it will stay lower, I am thinking more into probably the 26% range.

Matthew Clark

Okay. And then why you are not interested expense run-rate that you gave guidance of 285 for the overhead ratio for the end of this year which is, you got some branches consolidated this quarter. Is there some potential that we can see, further relief from the run-rate from that 26.4% this quarter?

Brian Vance

Yes, I think we are, we talked about this little bit last quarter. We are not going to see a lot of benefits from them but still we are consolidating heavy since consolidation cost even in Q2. We will see more of the impact starting in Q3 but we will expect to see occupancy and equipment expense to decrease sum as results and an overall non-interest expense as a result.

Matthew Clark

And then just on fees, gain on sales has been down the last couple of quarters, just curious what your thoughts are on production there and gain on sale income?

Brian Vance

Brian would you like to comment to that?

Bryan McDonald

Sure Matt, you know the pipeline at the end of the quarter was up to over $41 million versus $29 million at the end of the fourth quarter so we are seeing the pipeline ramp up on the mortgage side. On the SPA volume we are just seeing more competitive pressure in that market and we have a formula we used to determine whether we want to sell those loans or not so to the extent we are offering fixed rates or lower variable rates. We may sell a little less of that product than we have previously.

Matthew Clark

Okay. Sounds like with the pipeline building any more with the competitive pressure on SPA, you should see some improvement here going forward?

Brian Vance

Yes, the pipelines definitely up from where it was at the end of the year.

Matthew Clark

Okay. Thank you.

Brian Vance

Thanks Matt, we appreciate it.

Operator

Okay. And our next question comes from the line of Tim O'Brien with Sandler O'Neill.

Tim O'Brien

Good morning. A quick question for you Don. The provision reversal expense for loan loss is at $639,000 number this quarter in the table in the narration, what was that?

Donald Hinson

I am sorry what, where are you looking Tim?

Tim O'Brien

Page 4, chart top.

Donald Hinson

Okay. That's related to the capital estimation on purchase loans so in total we actually have an expense Tim. Because reversal is a positive number in Q4 last year. It is actually expense.

Tim O'Brien

Okay. Got it and it is actually related to purchase loans?

Donald Hinson

Yes.

Tim O'Brien

Okay. And then I guess that's self-explanatory in the table above, I didn't see that purchase loans section. And then the other question is, I think you alluded to this, the three loans that were downgraded this quarter to non-accrual. Were those purchase loans?

Donald Hinson

Yes, I know Bryan has that information.

Bryan McDonald

Looks like maybe one of the three were.

Tim O'Brien

Were any, can you give a little color Brian on the CNI loans; I think one of those was a CNI loan.

Brian Vance

Are we talking about the non-accrual loans?

Tim O'Brien

Yes.

Bryan McDonald

I think the CNI loans was the charge off that we had mentioned in the press release Tim. So, I think these are CRE loans that are related to the additional non-accrual balances.

Tim O'Brien

And the CNI loan that was charged up, that was identified and charged up in the quarter?

Brian Vance

Yes, it was and just to further color on that there was, it was fully charged off so that there is no balance left. There is a potential for some recovery on that loan but little additional information.

Tim O'Brien

Where was that the barware based where that loan was tied to?

Brian Vance

The barware was based in I would say North Seattle.

Tim O'Brien

North Seattle? And was it, how old was the loan?

Brian Vance

It had seasoned, it was a and not that this makes any difference but it was a legacy Whidbey island originated loan and it had been originated, I am going to say probably four years, three to four years ago.

Tim O'Brien

And then sticking with credit can you give a little bit of color on that $14 million reduction in problem loans kind of what was, that was a nice improvement and how did that come about this quarter?

Brian Vance

Yes, I think Tim if you, in my comments I talked about the improvement in overall credit quality and as we major FIB there is a combination of let me find my remarks here, combination of non-performing assets, restructured performing loans and potential problem loans. And that improvement rate has been going on for some time and we had a very nice improvement rate in 2015 and it continues in Q1 of 2016 and it is really just the ongoing management of problem assets and as I said it's a variety of different assets and variety of different types of loans and buckets of loans. I think our credit administration is doing a nice job of managing problem loans out of the bank. If there is an opportunity to do that than we are taking advantage of it, so it is just a continuation of our strategy.

Tim O'Brien

Okay. Thanks for answering my questions.

Brian Vance

Certainly, appreciate the questions.

Operator

Okay. And our next question comes from the line of Riley Stormont with D.A. Davidson.

Riley Stormont

Hey good morning guys, I know previously you talked about being a bit more selective in hiring for 2016. I wanted to know if there are any certain markets you have identified or fitting opportunistic in.

Brian Vance

Bryan you want to comment to that?

Bryan McDonald

Yes, sure Riley. We continue to actively recruit in King peers since the Hamish County you know primarily to replace for retirees or other people that have departed the bank and then really in all our markets, if we have a situation or somebody is retiring, we need to fill up positions so we continued to be very active in the recruiting primarily because that the talent is pretty limited and we always want to be out in front and aware of who's available or may become available and be in that all the time. So we were pretty well staffed at the end of 2015 and continue to be out just active if we have a name.

Riley Stormont

Alright, great.

Jeffrey Deuel

And I would add to that Bryan's comments, we were chatting to this the other day and our net lender base really hasn't changed over the last few quarters but we are adding lenders all the time. We have a good deal of retirement activity. I think this is something that most community banks worry about as our lender base may age, they are retiring out and we are certainly experiencing that.

But I think the important thing is that we have been able to replace these lenders either with folks coming up through the credit administration area, loan analysis as well as hiring folks from the outside so our net lender base hasn't changed but we have hired several lenders which have been replacing some retiring lenders so I just wanted to add that additional color.

Riley Stormont

Alright, thanks. And on core margin tail wins, obviously you guys saw pretty big jump in core margin this quarter. Expecting any additions from investing excess cash moving forward?

Bryan McDonald

Well, I think we may be down to, there might be a little bit of that but we used a lot of that in Q1. Our average balance for the cash dropped from $114 million to $60 million in Q1. There is a chance we could drop that a little further maybe to $40 million or something in Q2 but obviously not big of a jump this next quarter as previously.

Riley Stormont

Alright, thanks guys.

Bryan McDonald

Thanks well appreciated.

Operator

Thank you and our next call, our next question comes from the line of Jackie Chimera with KBW.

Jackie Chimera

Hi, good morning everyone. I just wanted to make sure I understand the costs that are associated with the before branch closures in the quarter. I am sure I missed listening to your prepared remarks; I have to have a little bit lead. You previously discussed around $400,000 related to those? Is that what happened in the quarter and if not, could you provide an update on that?

Jeffrey Deuel

Okay. Jackie you talking about costs we incurred this quarter on that?

Jackie Chimera

At least I thought they were going to be incurred this quarter. Maybe I misunderstood.

Jeffrey Deuel

Yes, we incurred some this quarter and we incurred, actually we incurred some at the end of Q1 and we also incurred again $300,000 again in Q4. I would say somewhat that the benefit we got of the branch consolidations kind of may have offset the additional cost. I think we headed out with a couple of hundred thousand of cost in Q1 and I think we are going to probably also have that in Q2. And not get the benefits from this totally until Q3. I think that we talked initially be about $800,000 potentially if we restart this process of overall cost and looks like we are going to be in the area while we get it done.

Jackie Chimera

Okay. So that's must be in my notes where I got the $400,000 from the $300,000 that were taken in Q4 and then directly $800,000 for all in. Okay, that was helpful thank you. Did you notice any change in the depositor behavior following the rate increase that we saw in December?

Jeffrey Deuel

No we really didn't, we always say the first quarter is slow compared to other quarters and deposit growth and I think it behaved like it normally does in Q1 so we really notice that and we really didn't need to raise our rates either so it was situation where it really ended up benefitting us overall.

Jackie Chimera

Okay. Great and your, I am guessing that from a competitive standpoint you're not noticing anybody coming in and saying so and so is raising the rate and I think you should do the same, it's just kind of business as usual.

Jeffrey Deuel

Yes, for credit requirements stay pretty stable I think over the last few months.

Jackie Chimera

Okay. Great thank you that's very helpful. Everything else I have already asked.

Brian Vance

Okay. Appreciate it Jackie, thank you.

Operator

Okay. And at this time there are no further questions.

Brian Vance

Well if there are no further questions, I appreciate those listening in, those that joined us today, and those that may listen in later on recorded note. Appreciate your interest in our company. That concludes our call for the day. Thank you.

Operator

Ladies and gentlemen, this conference will be available for replay after 1:00 PM today through May 5, 2016. You may access the AT&T teleconference replay system at any time by dialing 1-800-475-6701 and entering the access code 390312. International participants dial 320-365-3844. Again, those numbers are 1-800-475-6701, and 320-365-3844 with access code 390312. That does conclude your conference call for today. We do thank you for your participation and for using AT&T's executive teleconference. You may now disconnect.

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