Heritage Oaks Bancorp (NASDAQ:HEOP)
Q2 2016 Earnings Conference Call
August 2, 2016, 11:00 am ET
Brian Lace - First VP
Simone Lagomarsino - CEO
Jason Castle - CFO
Bill Schack - Chief Credit Officer
Tim O'Brien - Sandler O'Neill & Partners
Tim Coffey - FIG Partners
Good morning, ladies and gentlemen, and welcome to the Heritage Oaks Bancorp Second 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 like to introduce your host for today's conference, Mr. Brian Lace, First Vice President of Heritage Oaks. Mr. Lace, you may proceed.
Good morning. Thank you for joining us today to review our second quarter results. Joining us this morning are Simone Lagomarsino, Chief Executive 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 may affect our company's future operating results and financial position. Such statements involve risks and uncertainties and future activities and results may differ materially from these expectations.
The speakers on this call claim the protection of Safe Harbor provision contained in the Private Securities Litigation Reform Act of 1995. For a more complete discussion of the risk 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, 2015, 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.
Thank you, Brian. Good morning, everyone, and thank you for joining us today as we discuss our results for the second quarter of 2016. We will start by sharing some business highlights and then we will 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.
I'm pleased to announce that the second quarter represented another strong quarter of loan growth. We achieved loan growth of over $42 million or 3.3% growth and was strongest in commercial real estate, Residential 1 to 4 family real estate, and commercial and industrial loan categories which accounted for over 90% of our quarterly loan growth.
Relationship banking activities remain our primary focus and during the quarter new loan originations were $109 million. Our loan pipeline remains strong at this time and we anticipate that we will continue reaching our target growth rate of 2.5% to 3% for the third quarter.
Loan payoffs declined by 37% compared to the prior quarter of $221 million. This is the lowest quarterly payoff level we have experienced since the first quarter of 2014.
Second quarter loan growth also benefited from lowest seasonal agribusiness line paydown since what we have typically seen this time of the year. Paydowns resulted in 5% decline in outstanding agribusiness loans in the second quarter of 2016 compared to a 20% decline for the second quarter of 2015.
2015 was a strong earnings year for our agribusiness lines which led to increasing deposit balances and lower operating line utilization in the first half of 2016 by this point. We have also more recently diversified the crop types in our agribusiness customer base which should result in less seasonality than we have experienced in prior years.
During the second quarter, we continue to have success with our interest rate swap products generating $65,000 in fee income. We also have several loans with swaps in our pipeline which should be booked over the latter half of the year.
Deposit balances grew by $24.5 million or 1.5% during the second quarter. Over 90% of deposit growth was in our non-interest bearing demand deposit account. Growth of non-interesting bearing demand balances was primarily from our agribusiness and commercial customers.
Our net interest margin grew by seven basis points to 3.63% for the second quarter of 2016 compared to 3.56% for the prior quarter. Non-recurring accelerated purchased loan discount accretion increased during the quarter contributing 7 basis points to our net interest margin more than the second quarter of 2016. This compares to 1 basis point for the prior quarter.
Going forward, we expect that we will continue to experience pressure on our net interest margin attributable to the low long-term rate environment. However we expect that loan growth will work to mitigate this issue and will support our net interest margin in the 3.45% to 3.55% range in the second half of 2016.
Our earning asset mix improved due to our strong loan growth resulting from our relationship banking efforts and we anticipate continued improvement in our earning asset mix during the third quarter as we move toward a longer-term optimal loan-to-deposit ratio of 90%.
At June 30, 2016, our loan-to-deposit ratio was 82.99%, up 419 basis points from 78.8% at June 30, 2015.
Now turning to our financial performance, net income available to common shareholders increased by $200,000 to $4.2 million or $0.12 per diluted common share compared to the linked quarter.
Net income increased during the second quarter due to $1 million reversal of provision for loan losses and a $700,000 increase in net interest income which more than offset $800,000 decline in non-interest income and a $400,000 increase in non-interest expense. Jason will discuss these details later in the call.
Credit quality improved during the quarter and non-performing asset as a percent of total assets declined further to the lowest level we have reached since 2007 before the economic downturn.
Non-performing loans decreased by 16% during the quarter and classified assets declined by 3%. The reversal of provision for loan and lease losses during the second quarter can be attributed to the continued improvement of various credit quality metrics. We continue to monitor the drought conditions in the California Central Coast region and to-date we haven't seen deterioration in any of our agribusiness credits nor have we had any drought related loan losses materialize at this point. We have however provided $1.7 million or 9.5% of our total $17.5 million allowance for loan on lease losses for possible drought related losses. This equates to roughly 15 basis points of total growth loans.
In addition we continue to perform property inspections of all agribusiness loans between $500,000 and $2 million, and third-party inspections for all our agribusiness loans in excess of $2 million, which includes verification of water resource availability.
The return on average asset was 87 basis points and the return on average tangible common equity was 9.34% for the second quarter, up from 85 basis points and 8.9% for the prior quarter.
We are pleased to announce a $0.06 per share dividend, which represents a 2.9% annualized yield based on our closing market price as of August 1, 2016, and a 49% payout ratio based on second quarter earnings. The dividend will be paid on August 31 to common shareholders of record as of August 15. 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 returns to shareholders.
And now, Jason, will discuss additional details about our financial performance and he will conclude with an overview of the local economic trends.
Thank you, Simone. Our net interest margin increased by 7 basis points during the second quarter compared to the linked quarter. As Simone mentioned, much of the increase can be attributed to non-recurring loan interest income. Our earning asset mix also contributed to improvement in our margin as demonstrated by the linked quarter increase in our loan-to-deposit ratio from 81.6% to 83%.
Finally, non-interesting bearing demand deposit growth had an increase in a relative level of non-interest bearing demand deposits to total funds up to [indiscernible] in the second quarter. However loan payoffs and refinance activity continues to impact our loan yields and on average accounts for 1 to 2 basis point decline in our demand every one quarters depending on relative size of yield of our origination and payoff volumes.
During the second quarter, the yield on new loan originations averaged 3.95% while loan payoff average 4.54%. Our cost of funds held steady at 34 basis points at the second quarter of 2016 as compared to the first quarter and we saw very little change in our cost of deposits which remained at 23 basis points for the first and second quarters.
Security deals were also fairly consistent compared to the linked quarter at 1.99% for the second quarter up 2 basis points from the first quarter, due to the stability in prepayments fees on certain sectors of the bond portfolio such as FDIC closing rate pools and agency mortgages.
During the second quarter net interest income increased by $700,000. This increase was driven by $52 million or 4.1% increase in average loan balances and by an increase of $342,000 of non-recurring income related to loan containment activities.
As Simone mentioned, we reported a $1 million reversal of provision for loan and lease losses during the second quarter. This reversal is attributable to improvement in credit metrics such as the decline in classified assets and non-performing loans. For example the amount of classified loans as a percentage of our total Tier 1 regulatory capital plus our allowance for loan and lease losses has declined from 25.2% as of June 30, 2015, to 20.7% at June 30, 2016.
Our total non-performing assets and the amount of relatives to total assets has also improved from $12 million and 0.65% respectively at June 30, 2015, to $6.9 million and 0.35% respectively at June 30, 2016. At June 30, 2016, $6.1 million or 88% of our non-performing loans were paying in the Group.
Finally we have experienced net recoveries over the last eight consecutive quarters further indicating that our credit profile isn't good. Non-interest income was $2.6 million for the second quarter down $800,000 from the $3.4 million a quarter to a linked quarter. The decline in non-interest income was largely due to $467,000 decline in swap fee income and $464,000 decline in gain on sales investment securities when compared to the linked quarter. Offsetting these negative variances was $129,000 or 23% increase in mortgage banking revenues. This increase in mortgage banking revenues attributable to 21% increase in mortgage sales volume compared to the linked quarter.
We executed additional swap transactions during the second quarter however the dollar volume of these transaction was considerably less than the first quarter. We continue to identify swap opportunities and we anticipate that we will have additional swap fee income during the second half of the year. The decline in investment security advance through the second quarter is attributable to repositioning activities during the prior quarter. Following continuously monitor our existing securities portfolios relative performance given change in the economy and the shape of the yield curve, the amount of resulting security will can vary significantly from one quarter to the next.
Securities sales volume declined from $57 million during the first quarter to $18 million for the second quarter. Given our second quarter results and our expectations for mortgage and securities sales activity as well as new swap transactions, we anticipate that our non-interest income for the third quarter will be $100,000 to $200,000 higher in the second quarter results.
Non-interest expense increased by $400,000 during the second quarter as compared to linked quarter, due to a $289,000 increase in salaries and benefits cost, a $194,000 increase in other expenses, and $86,000 increase in professional services which was offset by a decrease in write-downs of other real estate owned of $217,000.
The increase in salaries and benefits cost was both to incentive compensation and full reversals of credit reported during the first quarter of 2016 as well as to increased mortgage commissions in the second quarter due to a higher level of origination volumes.
Base salaries also increased marginally as our full time equivalent employees increased from 293 at March 31, 2016, to $298 at June 30, 2016. The increase in FTE over the last quarter was driven by new hires we filled up position.
Other expense increased primarily due to $219,000 increase in operating expense. At the end of the prior quarter we anticipated that our operating losses were declined by approximately $100,000.
However additional unanticipated debit card losses which appear to have been related to compromises at several merchants in our markets resulted in an increase in operating losses. These losses began to materialize over the last half of first quarter and continued to the second quarter. Pursuant to Regulation E we are required to reimburse our debit customers for losses on transactions processed outside of our agency.
We are finalizing our own review of the root cause of these losses and are taking additional preventative measures including the issuance of new debit cards with MD check and statements. We anticipate this will help to mitigate future losses and we've already begun to see significant decline in losses during the month of July.
Professional services expense also contributed to linked quarter drive as much.
At the end of the first quarter we anticipated that our professional services expense would be flat by slightly lower percentage. However we practically decide to invest in cyber security during the second quarter and incur higher BSA remediation costs than previously anticipated results in an increase in professional services expense.
We anticipate that because the federal security review will not repeat because we expect that final BSA remediation cost that our professional service expenses will decline by $100,000 to $200,000 during the third quarter.
The decrease in write-downs and ORE is attributable to the write-down on one property which occurred during the first quarter. The write-downs related to these earning in that property which changed possible use and therefore negatively impacted expense.
During the third quarter we expect the non-interest expense will be $400,000 to $500,000 less than second quarter results. This decline was primarily attributable to anticipated decreases in professional services expense and operating losses.
Income tax expense increased by $184,000 or 7.6% during the second quarter compared to the prior quarter concurrent with the 6.5% increase in pre-tax income. Our effective tax rate increase from 37.8% for the first quarter to 38.2% for the second quarter of 2016. Our share repurchase program is not active during the second quarter. We continue to exceed the regulatory capital ratios acquired we generally consider as well capitalized.
The economic indicators continue to improve in the accounting which we operate. The trend in unemployment rates continue to decline across the tri-counties. In San Luis Obispo County, the unemployment rate as of May 2016 decreased to 3.5% from 4.3% primarily. Santa Barbara County declined 4% compared to 1% reported in February. Ventura County declined to 4.5% from previous 5.1%. All are still below California's unemployment rate of 4.7% which declined from February 5.7%.
Median home values as of June 2016 continue to show year-over-year increase in all three counties. San Luis Obispo County increased by 8%, while Santa Barbara County increased by 4.6%, and Ventura County increased by 6.8% over the last year.
The commercial vacancy rates also continued to improve in Paso Robles at year-end 2015 rate was 1.1% at San Luis Obispo was 3.3% and Santa Maria declined 5.4% at the end of the first quarter of 2016 Santa Barbara County has declined 2.9%. And for the same period Ventura County declined 4.3%.
I will now turn the call back over to Simone.
Thank you, Jason. I would 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, the order is entirely related to Bank Secrecy Act and anti-money laundering compliance. We believe we are near the conclusion of our remediation effort and we believe that we corrected the vast majority of issues identified in our 2014 BSA Consent Order. We look forward to successful resolution of the quarter in due time.
We are pleased with our progress thus far in 2016 on growing our relationship banking business and marketing our new swap product and capitalizing on our plan to capture additional market share and we will continue with these efforts throughout the year.
The credit quality of our loan portfolio also continues to improve. We firmly believe that we have positioned our company to be the community bank of the Central Coast further enhancing our franchise and shareholder value.
And at this point, we'll now open the lines for questions. Operator will you please explain the process.
Thank you. [Operator Instructions].
And our first question comes from Tim O'Brien with Sandler O'Neill & Partners. Your line is now open.
First question, do you have the headcount in your BSA compliance group or your total compliance group, I know it was 13 a quarter or so ago.
It is 14, we'll right at the point of filling one positions, I'm hesitating a little bit of either 13 or 14, but there -- we did a whole staffing analysis and we came up to a need of 14 and so we're either by the 13 or 14, but the goal would be to be at 14. As we go into 2017 our focus will be really trying to use systems and technology to become more efficient and how we're handling BSA hopefully reduce that down by a few positions as we deploy those employees in other areas of the organization.
Is the cost associated with that transition being realized now, if you looked at it kind of as a technology based initiative, compliance initiative for the company is that cost baked into the numbers that we're seeing now or is that incidental we'll see here in the back half of the year?
In the projection that Jason made for the next quarter the numbers are included in the expense production.
Great. And I know that you had said in the past that 14 is a full complement of staff for compliance. So sounds like you're pretty close. Do you have an update on when your -- you anticipate the exam of your annual safety and soundness will start?
As we've said in the past, we will have an exam this summer, and then it will -- we will need to wait until we hear back from the regulators that they concur that we completely remediated all of the issues in our BSA area. As I mentioned in this call we believe that we have remediated the vast majority of the issues in that we now have a robust BSA compliance area. But that still has to be validated by the budget.
And then question for Jason, hey Jason can you quantify that debit and credit card related losses in 2Q compared to 1Q, do you often have, can you quantify those?
Sure. In the second quarter they are approximately $450,000. And in the first quarter they were closer to $200,000 and in the first quarter they were elevated compared to our historical experience as well. Our historical experience is run more of the sub $100,000 quarterly budget.
And as far as tacking the problem as concerned do you feel like that where -- how should we look at that on a go-forward basis in terms of cost per tenants [ph] though. You give a little bit of color that it looks like the situation is resolving or you've shown some resolving at the start or the beginning of July is that the outlook is that kind of recede back to a more normal sub $100,000 level?
Yes, if we continue with our July -- if we continue with our July run rate, we should be in between that $100,000 to $200,000 range on a quarterly basis. The same we can predict is if some new subs come out, we are taking with safeguard, we are also implementing more systems that will be able to identify these transactions more quickly in the future. So that anything could be stopped sooner not that has been a big issue here, but really we just had a confluence that several vendors get hit at the same time, so.
And did you Jason say that you guys are going to convert your cards to chip cards and that process is underway?
And what's the -- is there incidental cost it's one-time in nature that will hit in the third quarter as a result of that conversion?
Yes I think over the next several months, you will have something roughly around $100,000 that might impact the numbers.
And that's already included in the number statements reported earlier.
And then last question just a balance sheet question, as far as your securities book is concerned does that, is it fair to assume that portfolio is going to remain relatively stable and I will use that relatively term liberally because you've adequate funding from a loan to deposit standpoint. Are you going to -- or is that portfolio going to shrink and take the cash and employ it in the loan --
So that's all depending on --
Is that the main change you're talking about?
Okay. So that's all depending on deposit inflows.
We have some cyclicality in our deposit portfolio. So to the extent that we can fund with the deposit portfolio we would maintain the securities portfolio around where is that thing.
All right, thanks very much.
And I'll also make sure [ph] our total is to get to a 90% loan to deposit ratio, which should mean overall potentially a bit smaller, our securities portfolio being a smaller percentage of our overall asset base, well absolutely.
That cash and that kind of that liquidity buffer that you have at around little over $50 million, that's where the banks going to kind of maintain that bottom given your size right.
Yes that sounds right, I mean yes our cash positions as you see them 6/30 balance sheet that is where we tend to be.
Thank you. And our next question comes from Jackie Chimera with KBW. Your line is now open.
Hi this is actually Sleece [ph] on for Jackie.
Good morning, Sleece.
Good morning. So you guys talked a little bit in your press release about utilization on the loan to credit growth. So and you also discussed that Ag went down, I'm just curious if you have the utilization rates for 1Q versus 2Q?
No I don’t think we have that at our fingertips here.
Okay. And did you guys have been -- did you guys have any repurchases during the quarter?
Share repurchases no.
Okay. And then as far as the large network however you go, is there anything in particular that drove that?
So we have continued improvement in our overall credit quality, we didn't have a large recovery from one specific loans and that seems to be working on for a couple of years and it finally came to provision. However, in terms of whether we would have a credit provision in our negative provision going forward in our allowance for loan lease losses, we don't really project credit or charges to allowance for loan and lease losses what we do is, do our analysis every quarter and let's say, where our credit quality trends have moved and then make the decision on whether we have to provide or reserve out of our allowance.
Thank you. [Operator Instructions].
And our next question comes from Tim Coffey with FIG Partners. Your line is now open.
Simone as I look at kind of the closed loan, I'm sorry the loans held-for-sale at quarter end will be about $2 million higher than they were at the end of 1Q. Can we perhaps simply that your mortgage banking business could be a little bit stronger in the third quarter?
Yes I mean we think that we will be consistent with what we did in the second quarter but what we do see coming is a shift in the originations for sale versus our portfolio of product. We had higher allocations to portfolio of products in the second quarter than we believe we will have in the third quarter, so that can all translate to an increase in the held-for-sale volume.
Okay. And Jason was that included a potential for stronger mortgage gains and those mortgage loans included in your estimates for non-interest income?
Slightly higher, yes.
Okay. Good and Simone, could you, you mentioned a little bit about diversifying the crop types in the agribusiness to less than seasonality. Can you give a little more detail on what you're doing there?
Sure, we actually reduced our percentage of loans that were in the berries, such sector and then increased lemons and avocados and it’s just happened back from a cash flow for the line usage perspective that just kind of rounded out the line usage. So we are not seeing significant drawdown all at the same time, there are some varying over different periods of times. So it has helped eliminate that kind of real significant drawdown in the second quarter that we see and actually wasn't drawdown it was pay down. We saw significant paydowns in our agribusiness lines in the second quarter last year and in the prior years in this year we didn't see it because of the changes.
Okay. Does that push that those paydowns to another quarter or a different quarter rather?
It's just they have -- they cycle differently. So as some are paying off, some are advancing. So now trying to be even with all up. And we saw a small reduction, so it was down 5%, when utilization was up 5% they went down 20% last year. So that's what we're trying to do is minimize that significant impact that has had in the past.
Okay. And as far as the BSA goes, are we just looking essentially waiting for the regulators to validate the process -- the progress that you have made and remedying those kinds of issues?
As we've indicated yes, we believe that we have remediated the vast majority of the issues and now it's a matter of time and having back validated for the regulators.
Thank you. And we do have a follow-up question from Tim O'Brien with Sandler O'Neill & Partners. Your line is now open.
Hey quick question for Jason that the, the reversal of accruals in the comp number do you have that dollar amount Jason and what exactly was that again how did that work?
Well, I don't have again the specifics of how the -- why the reversal occurred but I can tell you that the amount was about $150,000.
[Indiscernible] I'm sorry, that needs a reversal of incentive accruals some. So we would be basically given some of the metrics in our plans from last year and so as a result, we ended that having accrued more than we actually needed and so we reverse about 50,000. Hopefully that will make sense.
Thank you. [Operator Instructions].
And I’m showing no further questions at this time. I would like to turn the call back over to Simone Lagomarsino, CEO of Heritage Oaks Bank's for closing remarks.
Thank you all very much for participating. This concludes Heritage Oaks second quarter 2016 Investor conference call. Thank you.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day.
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