Heritage Financial Corporation (NASDAQ:HFWA)
Q2 2016 Earnings Conference Call
July 21, 2016 2:00 PM ET
Brian Vance - President and Chief Executive Officer
Donald Hinson - Executive Vice President and Chief Financial Officer
Bryan McDonald - Executive Vice President and Chief Lending Officer
Jackie Chimera - Keefe, Bruyette & Woods Inc.
Matthew Clark - Piper Jaffray
Riley Stormont - D.A. Davidson
Alex Morris - Sandler O’Neill & Partners, L.P.
Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial Second Quarter Earnings Conference Call. At this time, all telephone participants will be in a listen-only mode. Later, we will conduct a question-and-answer session; instructions will be given at that time. [Operator Instructions]
As a reminder, the conference is being recorded. I’ll now turn the meeting over to our host, CEO, Mr. Brian Vance. Please go ahead, sir.
Thank you, Laurie. I appreciate you hosting our call this morning. I’d like to welcome all that called in and those who maybe listening in later in a record-only mode. 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 on a pre-market release and hopefully you’ve got an opportunity to review the release prior to the call. And as always, I would ask that you refer to those forward-looking statements in that particular press release as we not only go through our prepared comments, but also for Q&A period the following our prepared comments.
Highlights of our second quarter results are diluted earnings per common share were $0.30 for the quarter ended June 30, 2016 compared to $0.29 for the quarter ended June 30, 2015 and $0.30 for the linked-quarter ended March 31, 2016. Heritage declared a regular cash dividend of $0.12 per common share on July 20, 2016. Return on average assets was 0.96%, return on equity was 7.39%, and return on average tangible common equity was 10.03% for the quarter ended June 30.
Total loans receivables increased $66.7 million, or 2.7%, to $2.5 billion at June 30 from $2.43 billion at March 31 and increased $123.9 million or 5.2% or 10.5% annualized from $2.37 billion at December 31, 2015.
Don Hinson will now take a few minutes and go over some of our financial results. Don?
Thanks, Brian. I will start with the balance sheet, as I normally do. Net loans, as Brian mentioned, grew $66.7 during Q2 and year-to-date they have grown $124 million or 5.2%. The loan growth for Q2 was funded by the increase in deposits of $28 million during the quarter as well as FHLB Advances of $33 million. As a result of loan growth, our loan deposit ratio increased to 79.2% from 77.8% in the prior quarter and from the 76.6% at year-end.
During the quarter, the percentage of demand deposits to total deposits increased to 26.0% from 25.4% at the prior quarter-end. And the total non-maturity in deposits to total deposits increased to 87.7% from 87.0% at the prior quarter end.
Moving on to some credit quality metrics, while we continue to see overall improvement in the loan portfolio, the nonaccrual loans has experienced $1.5 million increase from the prior quarter to $13.9 million at June 30. Several of the new nonaccrual loans were previously classified as performing TDRs. Substantially all of the new nonaccrual loans are secured with commercial real estate. They are probably reserved for at June 30.
Potential problem loans also experienced $6.3 million increase from the prior quarter to $101.2 million at June 30. The majority of the increase was related to one borrower relationship with outstanding loans of $7.1 million. We do not believe that the increase in nonaccrual potential problem loans is a trend in our loan portfolio.
Nonperforming assets to total assets increased to 0.41% as of June 30 from 0.39% at March 31 and 0.32% as of December 31, due to previously mentioned increase in nonaccrual loans during the quarter. The ratio of our allowance for loan loss to nonperforming loans still stands at a very healthy 205%.
Net charge-offs increased $1.14 million to $2.36 million for Q2 from $1.22 million for Q1. Of the $2.06 million in commercial loan charge-offs in Q2, $875,000 related to one borrower relationship, and $1.0 million related to the closure of a purchased credit impaired loan pool. This $1 million charge-off related to losses that had built up in the pool over the last six years, which could not be recognized as a charge-off until the pool is closed, which occurred in Q2.
Although charge-offs are elevated this quarter, the management believes that we will receive some recoveries on loans that haven’t charged-off in the first-half of 2016. In addition, included in the carrying value of the loans are $17.5 million of purchased accounting net discounts, which may reduce the needs of allowance for loan losses on those related purchased loans.
Moving on to the net interest margin, our net interest margin for Q1 was 4.00%. There is a 4 basis point decrease from 4.04% in Q1. Pre-accretion net interest margin decreased 11 basis points to 3.71% for Q1 from 3.82% in Q2. This increase was due to decreased yields in the loan portfolio.
Noninterest income decreased $414,000 in the prior quarter, due mostly to decreases in recoveries on purchased loans, which we charge-off prior to the related acquisition. This decrease was partially offset by a $513,000 increase in the gain on sale of loans in Q2. Of the total gain on sale of loans in Q2 $881,000 related to mortgage loan sale gains and $361,000 related to SBA loans sales.
Noninterest expense for Q2 increased to modest $108,000 or 0.4% for the prior quarter, and has increased $398,000 or 1.5% from Q2 2015. These modest cost increases are net of the additional cost incurred with the Seattle metro [ph] strategy which was implemented in mid-2015.
Bryan McDonald will now have an update on loan production.
Thanks, Don. I am going to cover the production activity during the quarter for each of our primary lending areas starting with commercial banking.
During the second quarter, the commercial teams closed $211 million of new loans which is up from a $151 million closed in the first quarter of 2016 and $184 million closed in the second quarter of 2015. Gross loan total increased during the quarter by $65 million as a result of the strong level originations.
Commercial team pipelines ended the second quarter at $273 million, down from $310 million at the end of the first quarter of 2016. 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 36.9% versus 34.6% for the first quarter of 2016. The line utilization percentage in the last three quarters is down from the 38% to 39% range which had been more typical over the prior two years. The average second quarter interest rate for new commercial loans was 3.93%.
SBA 7(a) production in the second quarter included 21 loans for $7.3 million and the pipeline ended the quarter at $13.5 million. This compares to the first quarter of 2016 when we closed 10 loans for $2.4 million and the pipeline ended at $12.8 million. Consumer production during the quarter including both direct and indirect originations was $41.4 million which is in line with the prior quarter.
Our mortgage department closed $43.6 million in new loans during the second quarter, compared to $29.6 million in the first quarter of 2016. The mortgage pipeline ended the second quarter at $38.6 million, down from $41.1 million at the end of the first quarter. The current pipeline is comprised of 50% refinanced loans, 36% purchased loans and 14% construction loans. This compares to last quarter’s pipeline where refinance business also averaged 50%.
Brian Vance will now have an update on capital management as well as some closing comments.
Thank you, Bryan. I’ll start with capital management. Our tangible common equity increased slightly to 10% and our strong TCE levels continue to give us flexibility for a variety of growth opportunity, as well as other capital management strategies. We don’t often focus on this metric, but I believe it’s important to note that our tangible book value per share increased 9.7% year over year or June 30, 2016 over June 30, 2015.
Few comments about my outlook or the bank’s outlook for the balance of 2016, we continue to be optimistic about the overall economy of the Puget Sound region. There continues to be strong inward migration, especially in the Seattle MSA. Commercial real estate construction continues to be robust and we remain disciplined in monitoring and preventing any undue commercial real estate loan product concentration risk.
Construction activity continues to seem to match demand at this point. Managing our concentration levels has and will continue to modestly mute our loan growth. As stated earlier, annualized loan growth for Q2 was 10.8%. Annualized loan growth for the first six months this year was 10.5% and year-over-year loan growth stand at 7.6%.
I will repeat my reminder that the loan growth is rarely perfectly linear. Our 2016 loan growth guidance is 6% to 8%. But given our year-to-date loan growth, our full year 2016 loan growth may be on the upper-end of that guidance for 2016, but it is not likely to remain in the double-digits range for the entire year.
While overall loan quality metrics ticked up slightly in Q2, as Don mentioned, I am not particularly concerned about it. Just as loan growth is rarely linear, the quality of a conscientiously managed loan portfolio is also rarely linear. For instance, as Don mentioned, a C&I credit with a total relationship of $7.1 million was downgraded in Q2, and is likely to be upgraded by end of year as we’ve already seen improvement in this credit.
Additionally, our loan quality is measured by the sum of total nonperforming assets, restructured performing loans and potential problem loans has improved 4.8%, since December 31, 2015. Also our NPAs, although a low overall dollar total, have improved nearly 50% year-over-year.
We continue to focus on growing core deposits and specifically noninterest bearing deposits. We have consistently guided for 8% to 10% noninterest deposit growth. While year-over-year total deposits have grown at a respectable rate of 7.2%, our noninterest deposits continue to grow at double-digit rates. Our noninterest deposits grew at an annualized rate for Q2 at 13.3% and our year-over-year noninterest deposits grew at 12.9%.
Total non-maturity deposit levels now stand at 87.7%. Expense management remains a primary focus of the company. We are pleased that our overhead ratio continues to improve and we believe we will continue to see improvement to this ratio. While the efficiency ratio is an important metric to follow, it is still dominated by the effects of net interest margin or NIM.
For instance, our total noninterest expense was virtually flat from Q1. But our efficiency ratio went up because NIM went down, while the same time our overhead ratio improved. The dominance of NIM in the efficiency ratio calculation masks improvement and possible deterioration in expense management.
Another point for folks to keep in mind is that our efficiency ratio continues higher than some of our peers, partially due to our leverage or loan to deposit ratio being lower than most of our peers. A more highly leveraged balance sheet in loans versus securities will produce on balance a more favorable efficiency ratio.
We would like to see more leverage in our balance sheet and that is certainly a longer-term goal of ours. Additionally, it is important to remember this noninterest expense improvement has been accomplished while adding significant new expense for our Seattle office. While we have previously guided to an overhead ratio of 2.85% on a run rate basis by end of year, however Q2 overhead ratio was 2.87% or only two basis points off our previously guided end-of-year run-rate.
While we believe improvement of this ratio will continue. The forward improvement rate is not likely to be at the same pace as in the past. All in all, we believe the first six months performance of the company has been strong.
That completes the prepared section of our comments this morning. I’d welcome any questions you may have. And once again, we refer you to the forward-looking statements in the press release as we answer those questions. And, Laurie, could you please open the call to questions. We’d appreciate it.
[Operator Instructions] We have a question from the line of Jackie Chimera with KBW. Please go ahead.
Hi, good morning, everyone.
Good morning, Jackie.
Brian, can you go into a little bit more detail on - and I’m assuming it’s just increased regulatory scrutiny, but just more detail on why your caution level on theory is - it appears to be increasing? Obviously, you have exposures, but as a percentage of capital you’re definitely not one that’s screams [ph] higher on that. So I just love to get your thoughts on all of it.
Certainly, Jackie, and that’s an important question. And you touched on part of the CRE growth being a regulatory issue. Certainly, we stand at a - I think our investor-owned real estate, I’m recalling from memory here, but I think it’s around 220% range, so well under 300%. Let me just take that without maybe trying to pin down an exact number. So from that point of view, we are still, we are certainly well within guidance from a CRE perspective.
As you can see on our balance sheet, a lot of our growth is coming from the real estate side, whether it would be owner-occupied or non-owner-occupied, most of the demand in the marketplace is real estate based. And I think that while we’re comfortable with the overall CRE exposure, when you look at it by buckets, if you will, or by category type, there are certain loan types that are experiencing some very high demand and growth, for instance, multifamily.
And so as we take a look - when we talk about CRE concentration it’s not just the overall level, it really needs to get to product line. And so, when we start looking at product line, we really feel it is prudent to not only have an overall concentration, but to make sure we don’t have concentrations in individual product lines. And then, as a result, that causes us to get the - tap the breaks, maybe even place moratoriums on certain buckets, which does affect loan growth.
Now, while I feel that, I’m always quick to point out that the Puget Sound region is a very strong growth area. We are seeing improvements in growth rates and valuations. But I also think that - I think bankers need to be prudent that that growth rate is also not going to continually remain linear. And at some point it’s going to soften, so I think that - I think we had a pretty long history of managing our concentrations well. And we will continue to do so going forward.
Now, when you say concentrations, do you look at it as a percentage of your loan balances or as a percentage of your capital?
Both; we slice and dice our CRE concentrations in a number of different ways, as I said, by individual bucket, as a percent of overall loan totals, as a percent of capital. We look at it in many different ways.
Okay. And when you look to the strong real estate values within your area, particularly with the CRE concentrations, how do you - do you feel that those values are supported by the market?
Yes, today they are. I think I made my comments in my prepared remarks. Especially, on the construction demand side of the commercial real estate markets, we see that most of the commercial construction in most of the major food [ph] groups is supported by sales. So in other words, the construction stuff is being absorbed. But there is a lot of construction stuff coming online in the Puget Sound Region. And I think everybody needs to be prudent to not only manage the buckets and the concentrations, et cetera, but if demand all of a sudden starts to soften, there is a pretty strong level of future product coming on the markets and that can quickly affect real estate valuations.
Okay. Thank you. That’s great color. I’ll step back now.
We have a question from Matthew Clark with Piper Jaffray. Please go ahead.
Hey, good morning, all.
How are you doing? First one for me, I think you mentioned the rate on new loans being 3.93% in commercial. Is that all-in or is that just commercial, just trying to make sure?
Yes, Matt, this is Bryan McDonald. It’s C&I owner-occupied and non-owner, if you look at all loans the average was 4.06%.
Okay. Thank you. And then, when you think about your expense to asset ratio, median expectations at the end of this year, can you give us a sense for what you might be driving for next year? I’m sure there is more to do.
No question, Matthew. There is more to do. And I’ll tell you that as I was preparing for this call, it caught me a little bit by surprise. They were essentially at our end of year run rate guidance for Q2. That’s a pleasant surprise to be there this couple of quarters early. And as a result, we really haven’t had an opportunity to sit down and do some more math and to give maybe some updated guidance and perhaps next quarter we can do that.
Just off-the-cuff I think that 2.87%, I think where today end of your guidance was 2.85%. I think as a company, we need to be in the 2.70% range.
And I think when we get to 2.70% we need to be to 2.60%. And I’m not trying to place any timelines on this. But this remains a very strong focus of the company and will continue to. So I think maybe in stopping just short of giving some new guidance, we need some time on that, but it’s certainly a focus to continue to move that number down.
Okay, makes sense. And then, with all the success you had in Seattle, can you talk about may be future expansion plans, whether it’s organic or M&A, just updated thoughts there too.
Sure. In terms of the Seattle MSA, maybe I could use and that would include Everett to the north, Tacoma to the south. I think that we’re going to continue to see growth in those three major markets. And really the bulk of our growth is coming out of those major markets. So I continue to feel good about that growth. In terms of other expansion, we continue to look at other markets as a possibility of expansion. I may not want to get too much more detailed than that.
But I think we are buoyed by our success in Seattle. And I think we would like to continue that success. As it pertains to M&A, we continue to be interested, continue to look at opportunities and possibilities. And then we continue to guide I-5 corridor. I think that as we, and I’ve said many times, the I-5 corridor we continue to focus on that primarily for two reasons. One, we believe we know this market. And as a result, we believe we can effectively bank it. Two, and this is probably, obviously known to everyone, it’s a good market. And it’s a market just to continue not only organic growth, but potential M&A growth as well.
Okay. And then just a couple items on the income statement, the accretion this quarter, just curious if that included some accelerated accretion, just want to make sure we had the right to a normal accretion going forward.
Yes. It was a little higher than it has, than it was previously. It’s little elevated this time. There were some payoffs that led to that. But again the stuff that’s really hard to predict, last year it was about $1.8 million, it was almost up to $2.4 million this last quarter. Obviously a declining trend, going down, I wouldn’t necessarily expect it to be as high as it was this quarter going forward. But you just never know when you’re going to get certain payoffs that have large discounts on them. But it will be a declining trend going forward obviously. I would expect more last quarter’s number to be - to probably more in line with what you’re going to see going forward.
Okay. And then in fees, a couple of spots, gain on sale of loans obviously a lot stronger this quarter, thoughts there going forward? I mean, also in other fees I think kind of offset some of that strength, also curious about the outlook there.
Yes, the mortgage business continues to be quite strong, good purchase volume and this rate is extremely low. So we’re benefiting on both fronts in the mortgage business. The SBA pipelines holding up, while that business continues to be quite competitive, but our customer base also is a really, really good fit for both the 7(a) and 504 business. So mortgage outlook is strong based on the current pipeline.
And other fees, I think that was down I think linked quarter and kind of mitigated some of that strength, just curious what that was related to, the $1.657 million.
Okay, the other income. Okay. We mentioned now that we have - a big decline in that quarter over quarter was a decline in the recoveries of loans that were charged-off actually prior to acquisition of certain loans. So these are kind of - in the past, I think I’ve called these zero-balance notes or deficiency notes that were getting income off of. We have been getting a pretty - not steady, but higher levels in this category and it had dropped kind of to a much lower level this last quarter in that category. So that was about $400,000 of that drop.
And sounds like that we’ll stay at this level most likely going forward.
It will - it won’t be - just like the discount accretion this will continue to decline. It may not be as low as it was this last quarter. But there is that possibility, yes.
Okay. Thank you.
And our next question is from the line of Jeff Rulis with D.A. Davidson. Please go ahead.
Hey, good morning, guys. This is Riley on for Jeff.
Most of my questions have been answered. I just want to sort of get a general sense on how you feel about lone yields. Do you see those sort of firming up at all in the near future? Were you surprised the magnitude of movement this quarter?
Yes, Riley, we’ve just seen the curve flattened so much. In fact, we’ve got some dialogue, just looking at our prime based loans versus our fixed rates. And it’s just really a flat - it’s really a flat curve, so a big driver is the mix as well, how much real estate we’re doing versus C&I in any quarter. But generally rates are continuing to decline. So I wouldn’t say I was surprised other than just generally rates went down over the quarter I think more than what we expected.
It didn’t have anything to do with banking as much, as just the overall interest rate indexes in the market went down significantly. So we are still seeing good loan demand, but we are also seeing just very, very strong competition in the market and that’s the driver as far as the competitive crossover.
Okay. I appreciate that. And I know you guys gave some color on the nonaccrual loans early in the quarter. Just sort of want your general sense of the overall portfolio if there is any real concern right now, any shift, and how you feel about the total book?
Riley, I don’t. As I said in my comments, I think that if you are actively managing a portfolio and you’re recognizing the differences of individual loan quality as they may improve or deteriorate if you’re recognizing those quickly and moving them, it’s a constantly dynamic process. The loan that I mentioned in terms of - that we downgraded in Q1 it’s likely that it is going to be upgraded by end of this year. And I think that’s kind of the same thing with nonperforming. I think some of the nonperforming inflow was from my TDRs.
So it’s not necessarily newly recognized loans. It’s just that the changing conditions of the loans. But when I look at the overall portfolio, and whether you even look at it over in longer-term horizon, over the last 6 to 12 months, it has steadily improved. And when I say overall portfolio I’m lumping in nonperforming loans and the TDRs and classified loans et cetera, because those always fluctuate in and out of all of those totals as they migrate up and down.
So as we look at that longer-term, there has been a very strong and steady improvement. And even short-term, there was improvement. So the short-term blips don’t necessarily concern me. If I step back and just look at things from a 30,000 foot view and say what’s the quality of our portfolio overall, I continue to feel very good about it in and I don’t have any undue concerns.
All right, perfect. Thank you, guys.
[Operator Instructions] And we’ll go to Tim O’Brien with Sandler O’Neill. Please go ahead.
Hey, good morning, everybody. It’s actually Alex Morris on for Tim.
Good morning, Alex.
So you guys tried a lot of good color in your prepared remarks. I just wanted to follow-up regarding the construction. You guys mentioned that, you feel demand is meeting the supply that’s coming on right now. I was just curious with the uptick in balances this quarter and could you - and just kind of on a relative basis where your construction commitment stand today versus about 12 months ago?
Sure, Alex. This is Bryan. Yes, the construction commitments are up and then some of the balances, our funding, it’s pretty active - it’s a pretty active portfolio quarter to quarter, converting out of the construction phase some of the pay-downs during the quarter were out of the construction bucket as well either moving to perm or paying off.
It’s in that three country area primarily that Brian mentioned earlier, Snohomish, King and Pierce County is where both of those projects are. There are also some low-income housing projects that moved in during the quarter and will continue to. So it’s a variety of different types of loans generating that increase.
Okay. That’s great. Thanks for that. And you guys, I appreciate the comments you mentioned on kind of flattening the yield curve and loan pricing. Are there any particular kinds of loan categories that you guys are interested in right now where you’re seeing particular pressure?
Commercial is always very, very competitive. Also just in general, the market has lots of loan demand and activity. So, on the real estate refinance side we’re also seeing high levels of competition there. That can be pretty straight forward financing particularly if it’s a low loan to value type of transaction. So there are plenty of competitors in each of the categories that we’re operating in. And we feel very fortunate we have a really good customer base and we get a lot of opportunities out of that customer base to leverage on.
Okay. That’s great. Thank you. And then, just one kind of housekeeping on the income statement, last quarter you guys mentioned about occupancy and equipment expenses were likely to be elevated a couple hundred thousand this quarter. Are you still looking at maybe a little bit of a drop off moving into the third quarter or the back-half of the year?
Well, this in Q2 we had about $250,000 related to kind of residual branch closure expenses, related to some branch consolidations that we did. So that $250,000 in Q2 won’t be occurring in Q3.
Okay. That’s great. Thanks for the color guys.
Thank you, Alex. I appreciate it.
Thank you. And we have no additional questions. I’ll turn it back to our speakers for closing remarks.
Thank you, Laurie. Assuming there is no additional question, I once again appreciate everyone’s interest and continued interest in our company. And I’m sure that I’ll be seeing many of you in a couple of investment conferences coming up over the next couple of months. So thank you for your interest. And this concludes our call today. Thank you.
Thank you. Ladies and gentlemen, this will conclude our teleconference for today. Thank you for your participation and for using AT&T’s Executive Teleconference Service. You may now disconnect. Thank you.
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