Bank of the Ozarks Q3 2007 Earnings Call Transcript

Bank of the Ozarks, Inc. (OZRK)

Q3 2007 Earnings Call

October 12, 2007 11:00 am ET

Executives

Susan Blair - Vice President, Investor Relations

George Gleason - Chairman of the Board, Chief Executive Officer

Paul Moore - Chief Financial Officer, Chief Accounting Officer

Analysts

Barry McCarver - Stephens, Inc.

Charlie Ernest

Andy Stapp - B. Riley & Company, Inc.

David Bishop - Stifel Nicolaus

Leo Hamid

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Presentation

Operator

Good morning. My name is Shanda and I will be your conference operator today. At this time, I would like to welcome everyone to the Bank of the Ozarks third quarter earnings release conference call. (Operator Instructions) Thank you. Ms. Blair, you may begin your conference.

Susan Blair

Good morning. I am Susan Blair, Executive Vice President in charge of Investor Relations for Bank of the Ozarks. The purpose of this call is to discuss the company’s results for the third quarter of 2007 and our outlook for upcoming quarters. Our goal is to make this call as useful as possible in understanding our recent operating results and future plans, goals, expectations, and outlook.

To that end, we will make certain forward-looking statements about our plans, goals, expectations and outlook for the future, including statements about economic, competitive, and interest rate conditions, revenue growth, including our goal of accelerating our rate of revenue growth in 2007 as compared to 2006, net income, net interest margin, including the effects of the relatively flat yield curve and intense competition and our goal of maintaining and possibly improving net interest margin from the level achieved in the third quarter of 2007, net interest income, non-interest income, including service charge, mortgage lending and trust income, non-interest expense and our goals for decelerating our rate of increase in non-interest expense in 2007 as compared to 2006, and achieving positive operating leverage in the future, asset quality, including the effects of the current economic and housing market conditions, changes in residential mortgage market conditions, future growth and expansion, including plans for opening new offices, loans, lease and deposit growth, and changes in our securities portfolio.

You should understand that our actual results may differ materially from those projected in any forward-looking statements due to a number of risks and uncertainties, some of which we will point out during the course of this call.

For a list of certain risks associated with our business, you should also refer to the forward-looking information caption of the management’s discussion and analysis section of our periodic public report, the forward-looking statements caption of our most recent earnings release, and the description of certain risk factors contained in our most recent annual report on Form 10-K, all as filed with the SEC.

Forward-looking statements made by the company and its management are based on estimates, projections, beliefs, and assumptions of management at the time of such statements and are not guarantees of future performance.

The company disclaims any obligation to update or revise any forward-looking statement based on the occurrence of future events, the receipt of new information or otherwise.

Now, let me turn the call over to our Chairman and Chief Executive Officer, George Gleason.

George Gleason

Good morning and thank you for joining today’s call. We are pleased to be reporting record net income for the quarter just ended. While this record was only a slight improvement over our previous quarterly record net income, we feel good about this accomplishment, considering the current operating environment.

We are also pleased that our third quarter results generally reflect continued progress in achieving our key goals for 2007.

Earlier this year, we had stated four key goals for 2007, which are: one, accelerating our rate of revenue growth; two, decelerating our rate of increase in non-interest expense; three, maintaining or improving net interest margin; and four, maintaining good asset quality.

We also stated that we wanted to get back on a record earnings pace by year-end 2007, after pursuing our significant deposit, branching, and corporate growth initiatives in 2006.

Let me give you some specifics on our recent results.

First, let me discuss our goal of accelerating our rate of revenue growth in 2007. Net interest income, which typically accounts for about three-fourths of our revenue, increased 3.1% for the year 2006 compared to 2005. In the first, second and third quarters of this year, 2007, net interest income has increased 4.7%, 7.3%, and 10.7% respectively compared to the comparable quarters in 2006. That is exactly the sort of performance we had in mind when we articulated our goal of accelerating our rate of revenue growth in 2007.

As a result, we have achieved record net income in each quarter this year. The acceleration in our rate of growth in net interest income to date this year results from a combination of: one, growth in earning assets, and that’s primarily loans and leases; and two, quarter-to-quarter improvement in our net interest margin during the first two quarters of this year. Our net interest margin actually declined one basis point in the quarter just ended.

I will discuss our expectations for future loan and lease growth and net interest margin in more detail in a few minutes.

Our efforts to accelerate our rate of revenue growth from non-interest income sources have had mixed results this year. We have seen good progress in regard to income from deposit accounts, service charges, and trust, but it has been a challenging year so far in mortgage.

Income from deposit account service charges is our largest source of non-interest income and last year this category of income increased 3.5% compared to 2005. In the first, second and third quarters of 2007, income from deposit account service charges has increased 22%, 20.1% and 21.1% respectively compared to the comparable quarters in 2006.

A number of factors have contributed to this increase and our growth rate of service charge income in 2007. These factors include enhancements made in late 2006 in our processes for applying and collecting service charges, a large increase in our number of deposit accounts from our 2006 deposit growth initiative, and some small adjustments earlier this year in our service charge fee schedule.

Typically, mortgage lending income is our second-largest source of non-interest income. During the year 2006, our mortgage income actually declined 3.8% compared to 2005, and during the first and second quarters of 2007, despite generally slower housing market conditions, mortgage income increased 21.2% and 4.9% respectively compared to the comparable quarters in 2006.

However, during the quarter just ended, mortgage lending income declined 25% compared to the third quarter of last year and 27.3% compared to the second quarter of this year. Both the direction and magnitude of this decline were disappointing.

In our view, the third quarter results were more significantly impacted by factors of market psychology than economic fundamentals. Let me explain what I mean by that.

First, the tremendous media hype about problems in certain sectors of the mortgage industry seems to have made many buyers doubt their ability to obtain financing. For our customer base, which easily financed through various secondary market programs, including a resurgence in FHA lending.

Secondly, the proliferation of publicity about housing market conditions nationally appears to have turned many buyers into bargain hunters. Clearly many buyers are negotiating harder and many seem to be waiting for market deterioration before they buy.

Now I would love to give you good guidance on where our mortgage lending income is going but since, at last in our markets, it seems that conditions are being driven more by market psychology than economic fundamentals, it is especially difficult to predict when we will return to a more normal environment.

Trust income is another important source of non-interest income and we are pleased to have reported record quarterly trust income for the third quarter. During the year 2006, trust income increased a very favorable 16.4% compared to 2005. In the first, second and third quarters of this year, trust income increased 7.4%, 11.1%, and 16.3% respectively compared to the comparable quarters in 2006.

A slowdown in new bond issuance in Arkansas has restrained our growth in corporate trust income so far this year. However, we have continued to see good growth in our personal trust and investment management business, and we expect growth in these areas to continue to drive overall growth and trust income in the remainder of 2007.

Let me conclude my remarks regarding these various revenue categories by saying that we feel the results so far this year reflect good progress in achieving our goal of accelerating our revenue growth rate in 2007.

Decelerating our rate of increase in non-interest expense is another key goal for 2007. During 2006, we invested heavily in our branching and corporate growth initiatives, which contributed to the 15.7% increase in non-interest expense in the year 2006 compared to 2005.

In the first, second and third quarters of 2007, non-interest expense increased 8.8%, 7.8%, and most recently 0.2% compared to the comparable quarters in 2006. Clearly this reflects that we are on track so far in accomplishing our goal of decelerating our rate of increase in non-interest expense in 2007. In fact, our results have been even better than we expected as our absolute level of non-interest expense has actually declined in each quarter of 2007 compared to the immediately preceding quarter.

While we will strive to continue to carefully control non-interest expense, it would be unrealistic to expect that the aggregate non-interest expense level would decline further, but we want to continue to grow and expand our franchise and this will require increases in non-interest expense as we add new people and new offices and otherwise spend to operating and build our business.

Our goals going forward will be for our growth rate of non-interest expense to be below our growth rate of revenue, thus achieving positive operating leverage.

Our third key goal that we set for 2007 is maintaining or improving net interest margin. Of course, this is closely related to our goal of accelerating our rate of revenue growth, which I’ve already discussed. However, net interest margin is so important that we think of it as a separate goal and I want to talk about it separately as well.

During the first and second quarters of this year, our net interest margin improved 13 and 11 basis points respectively compared to the immediately preceding quarters. In our last conference call, we stated that our short-term goal was to maintain net interest margin at the second quarter level or hopefully improve it slightly over the next two quarters. We fell slightly short of that goal in the third quarter as our net interest margin declined one basis point.

At this point, we have not seen a broad-based change in our environment for pricing loans and deposits. Unfortunately, competition continues to be very challenging for pricing both sides of the balance sheet.

The improvement in our net interest margin since the fourth quarter of 2006 is primarily due to two factors. First, in 2007, we had moderated our deposit pricing somewhat following our deposit growth initiative in 2006 and we’ve allowed a number of higher cost deposits to roll off our balance sheet in favor of lower cost borrowings. And secondly, our loans generally re-price somewhat more slowly than our deposits and with the federal reserve on hold with interest rate adjustments for the last half of 2006. In the first eight months of 2007, our loan pricing during the first half of this year started to catch up somewhat with our earlier deposit repricing.

As we suggested in the last conference call, we expect that further improvements in net interest margin will be more difficult to achieve in the near term. At this time, our goal continues to be to maintain net interest margin at the third quarter level or hopefully improve it slightly during the coming quarters.

Our simulation model results suggest that we are almost neutrally positioned and the recent fed action should have little impact on our net interest margin.

The fourth goal for 2007 is to maintain good asset quality. Our third quarter asset quality ratios were very favorable and are consistent with this goal. Our strong credit culture and our commitment to good asset quality appear to be serving us well.

At September 30, 2007, our ratio of non-performing loans to total loans and leases was 19 basis points and our ratio of non-performing assets to total assets was 22 basis points. Our ratio of loans and leases past due 30 days or more, including past due non-approval loans and leases, as a percentage of total loans and leases was 45 basis points at September 30, 2007, and our annualized net charge-off ratio was 17 basis points for the last quarter.

As of the end of the most recent quarter, our allowance for loans and lease losses equaled 564% of total non-performing loans and leases.

Our good third quarter asset quality results might lead on to believe that we are operating in a very favorable credit quality environment. However, as I have said previously, the cumulative effects during the past two years of 425 basis points of FMOC rate increases, 50 basis points of course which have now been reversed, higher energy prices, and slower economic conditions in many sectors among other factors are adversely affecting some borrowers.

In all of our markets except northwest Arkansas, I would characterize business conditions as generally good, although activity has slowed in recent quarters. In northwest Arkansas, a slowdown in residential lot and home sales has occurred and that market is continuing to work through the oversupply situation.

The good news for northwest Arkansas is that there is by no means a cessation of residential lot and home sales and the area continues to be a growing and economically vibrant market which in due time should resolve the oversupply of houses and residential lots now existing in some sub-markets and some price points.

In summary, accomplishing our key goals of accelerating our rate of revenue growth, decelerating our rate of increase in non-interest expense, maintaining or improving net interest margin and maintaining good asset quality were critical elements in our favorable results in each of the first three quarters of this year, including our record net income in the quarter just ended.

These four goals will continue to be key objectives for the coming quarter.

Now, let me turn our attention to several other subjects.

Growth in earning assets, primarily loans and leases, is important in achieving our goal of growing net interest income. Loan and lease growth in each quarter this year has been below our expectations. Our quarterly loan and lease growth in the first, second and third quarters of this year were $46 million, $33 million, and $16 million respectively.

Over the last four quarters, our loans and leases have grown 13.9%, near the bottom end of our target range. Despite this slower growth in recent quarters, it appears that we have a very good pipeline for the fourth quarter and we continue to believe that in the coming quarters, our growth in loans and leases will on average be in the mid-teens to low 20s annual percentage range.

Our investment securities portfolio is another source of earning assets and as you will recall during the first quarter, we were a net seller of investment securities and we have found very few investment securities we thought were compelling values this year. This has been the primary factor in the $29 million decrease in our investment securities portfolio so far this year.

As we have said a number of times before, we will be a seller of securities when we believe market conditions are conducive to selling and a buy of securities when we believe market conditions are more appropriate for buying. We expect to continue to manage the securities portfolio with the same mindset.

After record-setting deposit growth in 2006 and very strong deposit growth in the first quarter of 2007, our deposits have actually declined in each of the last two quarters. This is not concerning to us. We have simply been trying to maintain or improve our net interest margin this year and over the last two quarters, we have allowed a number of broker deposits and other high cost deposits to run off in situations in which we could replace those deposits with lower-cost borrowings.

We continue to expect that our deposits will grow over time to the extent that deposit growth is cost effective and needed to fund our growth and earning assets, and we expect to use brokered funds and borrowed funds within reasonable limitations when borrowings are a cheaper source of funds.

Our goals for the coming quarters include continuing to achieve good growth in earning assets, primarily loans and leases, and maintaining or perhaps improving slightly our net interest margin from the third quarter level. If we can accomplish these goals, then we have the necessary elements to continue to achieve improvements in net interest income each quarter, and of course this is critical to our achieving earnings growth.

We have continued our growth in de novo branching strategy in 2007. In addition to our Hot Springs, Arkansas office, which opened during the second quarter, during the third quarter we replaced our original temporary office in Frisco, Texas with our second permanent office in that city and opened a second banking office in Fayetteville, Arkansas. In the fourth quarter, we expect to open our third banking office in Rogers, Arkansas. At this time, we expect to open approximately three new banking offices in 2008, including our new corporate headquarters.

Given the fact that 53% of our total banking offices have been open in the last four years and nine months, including the record number of new offices we opened in 2006, we believe we can maintain good growth rates while opening fewer offices in both 2007 and 2008.

In closing, let me state again that we are very pleased with our record third quarter net income. Now that we have once again achieved record quarterly net income, our goal will be to continue to improve earnings each quarter. We think this is a reasonable goal.

But given current economic, housing market, mortgage market, competitive and [yield curve] conditions, we are very cautious in our optimism. Given the considerable headwinds and uncertainties related to business economic and interest rate conditions, we presently see room for only modest EPS growth in the fourth quarter. We are also very cautious in our outlook for the first quarter of next year.

The first quarter, as many of you know, is always a challenging quarter, as it is usually a soft quarter for income from deposit account service charges, mortgage income and loan growth, and also typically includes some non-interest expense items unique to the first quarter.

Here’s the bottom line; we want to continue to report record earnings each quarter and that is our goal and we think it’s a reasonable goal, but we should all be cautious in our optimism for the coming two quarters and until conditions improve.

That concludes my prepared remarks. At this time, we will entertain questions. Let me ask our operator, Shanda, to once again remind listeners how to queue in for questions. Shanda.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Barry McCarver.

Barry McCarver - Stephens, Inc.

Good morning, George, and great quarter. George, just on your last comments there about you said in your comments, modest EPS growth for the next couple of quarters. I’m assuming you mean late quarter and how they would move up from compared to the $0.50 you had in the third quarter. Is that what you mean?

George Gleason

Yes, thank you for clarifying. That is.

Barry McCarver - Stephens, Inc.

Second question, just going back -- and again, you touched on the difficult environment for gathering deposits but in terms of the margins, seeing deposits come down 6% in quarter and running that loan-to-deposit ratio up to 89%, I would have suspected the margin would have been just a little bit stronger than it was. Could you give us some more specific details on the deposit line? It certainly indicates that was a much more competitive environment than what I thought was out there.

George Gleason

We had hoped to see more moderation in deposit pricing in most of our markets than we have seen. That has been very slow to come about and I think still has hopefully a ways to go. We were also surprised when Fed did make their 50 basis points cut. Some of our competitors did not adjust deposits as quickly or appropriately as we thought they should, so that’s part of my comment about being cautious about being able to improve that margin and also reflected in my comment regarding continued challenging competitive conditions out there.

Barry McCarver - Stephens, Inc.

So was there anything specifically large in the way of deposits that were running off in the third quarter that you just let mature and go, or there was just a little of everything?

George Gleason

It was significantly broker deposits and other higher cost CDs, were the principal sources of that and you saw that in the change in the mix of our deposits. For example, last quarter our average CDs were 67.2% of our total deposits and this quarter, on an average basis, they were 66.4%, so a decline in CDs in the mix of deposits and that was the principal source of run-off.

Barry McCarver - Stephens, Inc.

Okay, so the bottom line is it sounds like a flat margin is what we can expect for the next couple of quarters, all thing being equal, hopefully?

George Gleason

Again, our guidance was we hope to maintain it at the third quarter level and improve it slightly but generally flat is our expectation, plus or minus a tad.

Barry McCarver - Stephens, Inc.

And then just secondly, on the expenses, it continues to be very impressive the way you are holding expenses down. I am surprised that so much of it is coming out of salaries and bonus. I know part of that must be related to commission basis on the mortgage business and probably some of it relates to some of the hiring you did in 2006. Can you break that down just a little bit further so we’ve got an idea of what to look for next quarter? And then, in addition to that, I’m assuming you are going to have some bonus accrual and potentially some catch-up in the fourth quarter as well.

George Gleason

That’s going to depend purely on our earnings whether or not we have bonus accruals and catch-up. We have had fairly nominal bonus accruals in the second and third quarter. I think it was $100,000 we accrued for targeted bonuses in the second quarter, and I think it was $45,000 in the third quarter.

We want to get back on a program of either paying our general cash bonuses or, if we can’t pay the general cash bonuses, we want to get back on a program of paying targeted bonuses to employees who are performing at a particularly high level or making a particularly significant, noteworthy contribution to the company and we describe in our proxy material those two categories of bonuses, if you want to refer to that for more clarification on that.

So I am hopeful that we will have bonus accruals in the fourth quarter and in future quarters subsequent to that. But as you know, we have minimum earnings targets that we want to hit in order to accrue bonuses and obviously we slightly exceeded those earnings targets in Q2 and Q3, allowing us to accrue the $100,000 and the $45,000 in those quarters, so we have targets for Q4 and Q1 and the other quarters of next year, and we’ve got to exceed those earnings targets.

Now, I will tell you if we exceed those earnings targets, I am generally inclined to put a large part, if not all of that excess, into bonus accrual because I do want to get back on that bonus accrual and that’s in part of our mindset in being reasonably cautious in our guidance for EPS growth.

We certainly feel like our earnings trajectory has been very good in the first, second and third quarters of this year and we are on the path of accomplishing what we want to accomplish. I think it is prudent to realize that we are in a tough operating environment and not get carried away in ratcheting up future earnings projections too aggressively.

Barry McCarver - Stephens, Inc.

And then just lastly, same question I ask every quarter, George, but nothing in the loan book in terms of asset quality that has popped up that has you worried anymore than what’s been there recently?

George Gleason

And I’ll give you the answer I always give you, Barry, is I’m a credit guy by history and I always worry about everything but no, I think that the asset quality ratios for the third quarter are very reflective of the condition and quality of our portfolio. We worked very hard on asset quality.

To give you a little color on that, I would tell you those ratios are, depending on which ratio you look at, slightly better or slightly worse than the comparable ratios a year ago. I would tell you that we are spending more time on asset quality this year than we did last year and that’s just a reflection of the fact of what I commented on in the prepared remarks, but the higher interest rates, higher energy prices, generally slower economic conditions are causing some borrowers on the margin to struggle significantly.

And we sold quite a bit of OREO in the third quarter, including -- we had a number of accounts -- I think we sold five houses from our OREO portfolio in northwest Arkansas and liquidated a small church and a small retail facility that we moved out of OREO in the quarter, so it’s requiring a lot of work. Our guys are doing a good job. I think managing problem assets is a strong skill set that we have, as well as maintaining a strong credit culture and doing a good job of underwriting.

So all those skill sets are proving to be pretty valuable in the current economic environment.

Barry McCarver - Stephens, Inc.

Very good. Thank you, sir.

Operator

Your next question comes from the line of Charlie [Ernest].

Charlie Ernest

Good morning. George, my first question is on your loan growth outlook. The numbers are coming in a little bit lighter, as you pointed out, and I guess there is more concern about the economy, yet you still stick with the higher targets. Can you share any color with us as to why you still feel comfortable with those higher targets?

George Gleason

I’ll be happy to share that with you. I think an important consideration there is that we did enter over the last year to two years, we’re really entered or ratcheted up our presence in four new markets significantly. Northwest Arkansas is one of those markets. It is not contributing much growth at this time because of the slowdown in economic conditions there. Garland County, Arkansas, the Texarkana, Arkansas and Texarkana, Texas area and in the metro Dallas area.

And the metro Dallas market, both our real estate specialties group that’s headquartered in Dallas and our more metro Dallas retail offices, of which we opened the second of their offices this last month, is providing a significant chunk of growth for us. That was very evident in the third quarter when our percentage of our loans in Dallas increased from 11.6% at June 30 of this year to 14.6% at September 30, so I that quarter, Dallas increased or Texas, including our Texarkana offices as well there, increased their contribution to our loan portfolio by 300 basis points.

As a result, Arkansas loans in our portfolio went from 83.1% to 80.4%, a 2.6% decline, 260 basis points roughly decline there in Arkansas. So the Texas economy is very good, the metro Dallas economy particularly is very good. We have a large presence there. It is a fairly new presence. Our guys seem to be gaining traction there and I suspect that we will also see some growth from our Charlotte office and from our metro Little Rock area offices.

So we feel like there is still some really good growth opportunities available to us. Our growth so far this year in each quarter has been offset to some extent, reduced to some extent by a considerable number of pay-offs that we’ve experienced. We have an ongoing program of pruning the portfolio. We try to move credits out of the portfolio when we see signs of financial weakness beginning, when we see deteriorating credit trends and we talk with management and we talk with borrowers and they are not providing us the kind of answers and comfort and direction that we want. We are pretty aggressive in moving loans out of the portfolio.

So as economic conditions have slowed over the last year or so, we’ve seen a few more credits fall in that category than we have seen fall in that category in the prior few years and that’s led to a little bit more aggressive pruning, and that has tended to provide some headwind to our growth this year.

Secondly, we have a large construction and development portfolio and for obvious reasons, a lot of those guys are carrying less inventory.

So what I would tell you is there are some headwinds as folks borrow less under their prior -- compared to their prior borrowing arrangements because they are carrying less light inventory or less construction inventory, slower economic conditions are causing a little more pruning than normal of the portfolio, so those are headwinds.

On the flipside, we’ve got really good lending teams, we’re in some really good new markets where economic conditions are good, so that’s the positive things that give us optimism that we can continue to maintain a mid-teens to low-20s growth rate, on average.

Charlie Ernest

Can you just comment what the construction number was during the quarter at period end?

George Gleason

Yes, I can if I can put my fingers on that. The construction and land development loans at September 30 were $597 million. That was 32.9% of the portfolio, up from 32.0% of the portfolio at June 30. And again, as would be evident from the percentages that I gave you on the state-to-state mix of the portfolio, most of that growth occurred in our metro Dallas or Dallas real estate specialties group offices.

And what we really like about the product that we originate in those offices is in almost every case, we’ve got lots of equity in those projects. There’s a lot of equity money, a lot of wealth in Texas and our Texas loan portfolio typically has much higher equity contributions from the borrowers than we see in Arkansas, so we like that sort of business and I think it’s one reason you’ll continue to see our appetite and our portfolio of Texas loans grow significantly.

Charlie Ernest

How much of that 597 is land?

George Gleason

I could not -- I don’t have that number.

Charlie Ernest

Okay, and then just one clarification; you mentioned your operating leverage goal of positive operating leverage. Was that on an annual basis for the full year or was that sort of a blank quarter goal?

George Gleason

I think that’s an annual goal and you’ll see that number bounce around from quarter to quarter, for various reasons. You’ve asked questions about bonuses in the past and Barry asked a question about bonuses. If we had a particularly robust Q4, for example, we might make a particularly robust bonus accrual, or if we had some extraordinary income from some source, unusual income in Q4 we might use that to buttress bonus accruals and that would actually -- might lead to negative operating leverage as far as the efficiency ratio goes, but over time our goal is to achieve positive operating leverage.

We still have a longer term goal of getting to a 40% efficiency ratio and certainly the interest margin environment we’ve been in the last couple of years has caused us to not talk much about that and not view that as a near-term achievement, but over a period of several years, we still want to get to a 40% efficiency ratio.

Charlie Ernest

And then my last question is do you have any -- I know that you said most of your mortgage business is in the conforming space, but do you have any guesses as to about what percentage that is? It is 90% or 95%, somewhere around there?

George Gleason

It is well north of 90%. I would say it is in the 95% plus range. I don’t have third quarter data but last year, we originated I think about $10 million of sub-prime or Alt-A mortgages, which we sell immediately, non-recourse. We’ve got them sold when we commit to them so we are not taking any portfolio risk and that was about 5% of our total $174 million or so mortgage originations last year, so --

Charlie Ernest

Great. Thanks a lot, you guys.

Operator

Your next question comes from the line of Andy [Stapp].

Andy Stapp - B. Riley & Company, Inc.

Good morning. Last year you opened a record number of offices. I’m just wondering if you could give us an update on how they are performing.

George Gleason

I would say, as in any case where you open 11 offices like we did last year, they are performing with mixed results. Again, I would tell you our Texarkana, Arkansas and Texas offices, our Frisco offices are performing well -- let me clarify that.

I would say Texarkana, Texas and Arkansas offices we opened are doing very well. That’s turned out to be a very competitive environment, but the guys are generating good growth and good additions in number of accounts and doing well there.

Our Frisco office that we opened last year, we’ve really been sort of slow-balling that and the reason was is the office that we opened just a couple of months ago -- a month ago, I guess, will be our headquarters for that office and right after we opened the Frisco office, they started doing a whole bunch of roadwork right in front of our facility and access was very difficult. So we decided to not aggressively push that office, to just sort of slow play that office until the roadwork got done, which I think is all done now, and until we opened this office, the headquarters office down there in September. So we will begin really in earnest to push that office, so that office has been very slow to develop.

Our Hot Springs offices are doing very well, particularly on the deposit side, and our northwest Arkansas offices are, as you would expect from the economic conditions up there, ramping up at a slower rate than what we would have expected because things have slowed down up there considerably.

The good news, and I think the more important news is that I think all these offices are well-situated in markets that have strong, long-term growth potential, so whether or not they’ve outperformed our expectations, as a few have, or under-performed our expectations, as a few have, I think the long-term prospects for all of them are very good.

Andy Stapp - B. Riley & Company, Inc.

When do you plan to open your new corporate headquarters?

George Gleason

That will probably be completed in November or December of next year, so that really has no significant bearing on our ’08 operating results until the last month or two of the fourth quarter. And I would -- but I don’t think while that is a big new facility and it will bring some higher overhead costs, it will also bring some efficiencies and some reductions in cost.

I’ve got folks in two rented spaces in town now and other office buildings where we’ve just run out of space in our existing headquarters and we’ve pushed people out to other leased space in other buildings, and of course that lease cost will go away and offset to some degree the cost of a new facility.

And our existing facility that we are in now, we are not quite sure what we are going to do with that yet. We would very much like to keep the retail banking office downstairs. We think we’ll need this facility again in the future and potentially will lease it for a period of time until space is needed in it again, or we think we own it at a very favorable cost basis and if a really good offer to buy it came along, we would sell it.

So I think through the -- either leasing this space or eliminating the cost of the headquarters we’re in now by selling it and eliminating the cost that we are expending for lease space for other office buildings where we’ve got folks stuck now and achieving some productivity efficiencies by having all of our people back together and having room to do some things that we can’t do right now in our headquarters facility I think will mitigate a large part of the monthly operating costs of that new building with some savings.

Andy Stapp - B. Riley & Company, Inc.

Okay, great. That’s all for me, thanks.

Operator

Your next question comes from the line of David Bishop.

David Bishop - Stifel Nicolaus

Good morning, George. First question, in terms of loan pricing out there; obviously with the disruption in the secondary markets we saw with the liquidity issues in the early to mid part of August there, I had talked to some of our management team and some of them had been hopeful to see an improvement in terms of some of the risk-adjusted pricing out there, maybe some of the conduits, some of the insurance companies had stopped picking up the phones there. Have you seen any sort of evidence there as of yet in terms of on the loan pricing side? Obviously loan yields are down here. I would assume not. I guess I’m somewhat surprised at this stage of the credit cycle and to your overall commentary, we haven’t seen that translate through yet to loan pricing.

George Gleason

We are beginning to see some of that, both in volume opportunities and in pricing, and let me try to explain all that so I can help you understand the nature of the comments that I made.

First, we are seeing some opportunities to do some loan business with folks that would typically not use bank financing. They would typically be Wall Street money that would be proving their financing at very low rates and as you said, a lot of those money sources have dried up because perhaps they were overly aggressive in the past and they’ve got some problems and issues that they have to deal with, so they are turning off the spigots.

And customers who might not have accepted our equity requirements or loan covenant terms or pricing in the past, we’re getting some shots at some pieces of business from really primo, high-end, high net worth borrowers that we would not have had a shot at even talking to them about doing their business in years past.

So that is one reason to sort of follow-up on Charlie’s question, I guess, that we are somewhat optimistic about the high teens to low 20s loan growth rate going forward. I think we are going to have some business opportunities that we would not have had a year or two ago.

In regard to pricing, we are seeing in some categories of larger commercial credits that are really, really high quality credit, libor-based pricing and we are seeing that pricing up 20, 30 basis points or so where those loans would have been priced a few years ago, or a few quarters ago, actually.

And that is -- I think that augers well for the growth prospects of our Dallas area offices and our Charlotte area offices and also the margin prospects of those offices.

That is being somewhat offset in Arkansas, where we still have 80% of our loan portfolio, where the significant slowdown in loan opportunities in northwest Arkansas and the fact that Arkansas is a heavily banked state, seems to be creating even more aggressive competition, unfortunately, from the top tier players in Arkansas who were getting loan volume from northwest Arkansas and a lot of that volume has dried up, so they are becoming more aggressive in trying to steal business away in other markets.

So that’s providing some challenges on particularly good credits in some of these other markets.

So it’s a -- that’s why I said we’ve not seen really a broad-based change in competitive pricing conditions. In some instances, it’s gotten better and we are seeing opportunities to get 20 or 30 or 40 basis points better yields than we might have gotten a few months ago, a few quarters ago, and in some instances, we’re seeing unusually aggressive competition because the pie of available high quality, particularly larger loans in Arkansas has shrunk for some lenders and they are trying to make up for that with aggressive pricing in other markets. So it’s a challenging environment out there.

David Bishop - Stifel Nicolaus

Great color. One follow-up, I guess; Texas versus Arkansas, you are still seeing good ability there to price and loan fees in terms of the construction credits and other commercial credits relative to Arkansas, where I guess there’s been a little bit more of a legacy type resistance to that type of pricing.

George Gleason

Yes.

David Bishop - Stifel Nicolaus

Okay, great. That’s it for me. Thanks.

Operator

Your next question comes from the line of [Leo Hamid].

Leo Hamid

Good morning. Can you talk a little bit about whether or not loan growth in the quarter was allowed to accelerate because of the FED toward the end of the quarter?

You talked a little bit on the previous question about seeing opportunities of 20 to 40 basis points higher in profitability. Did that give you an opportunity to add more loans toward the end of the quarter.

George Gleason

The FED action had no effect on our loan growth whatsoever. Our guys are charged with this general instruction. We are a lending oriented company and I would say lending is our best skill and our guys operate under this protocol, and that’s to make every good quality, good yielding loan you can make consistent with safe, sound, and prudent banking practices.

The guys have a constant green light to make loans that meet our underwriting standards and our pricing standards and are otherwise documented, serviced and managed in a safe, sound and prudent manner. In our company, there has never been a restraint or a limitation on that. The guys have a constant green light to go do that, so FED action had no change in our policies there at all.

Leo Hamid

And then you talked a little bit about deposit prices and still being relatively competitive, even after the cut. Historically, how long has that taken to bleed through competitively and what are you seeing differently this time?

George Gleason

Leo, I don’t know that I can intelligently answer either one of those questions. We are in different markets to a great extent than we have been in the past. We’ve entered four new markets last year, so I don’t know that we can give you an apples-to-apples comparison of what’s happened in the past and what’s happened this time.

I would tell you and just reiterate the comments that I made earlier and that is that I would have expected, in response to a 50 basis point FED cut, I would have expected to see a little more moderation in deposit pricing from a number of our competitors beyond what I saw. We’ve still got competitors in some markets that are pricing CDs, Susan, in the 550 range?

Susan Blair

560.

George Gleason

550 and 560 APY range and I mean, I just don’t see any need for that. It’s surprising me that we’ve still got competitors doing that.

Now, there has been a general reduction in rates since the FED move. It’s just not been as much or as fast as I would have thought was prudently appropriate by people that are interested in their bottom line.

Leo Hamid

Fair enough. Thanks.

Operator

Your next question comes from the line of Brian Martin.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Good morning, George. Just a quick question, just on the growth over the last two quarters on the loan side, specifically within the Texas market. I guess, given some of what your commentary talked about, the northwest Arkansas and Arkansas in general, can you talk -- maybe you’ve done this and I’m just not aware of it -- but maybe what your short and long-term goals are, as far as kind of your Texas presence? It is specifically targeted at Dallas? Do you go elsewhere given the growth you are seeing down there? I guess maybe what color you can provide there?

George Gleason

We basically have three strategies in place that we are pursuing for Texas and one of them is what we call our real estate specialties group and we have a lending team that is located in metro Dallas in the Preston Center area there, and these guys have substantial experience and contacts and knowledge about larger commercial credits and we’ve been doing this now for several years there and this office is the principal contributor of our loan growth in Texas. And I’ve talked at length about this office at various times and this is a very important part of the future growth picture of our company.

So those guys are focused on larger, commercial real estate transactions, including construction and development lending transactions with very high-end developers and borrowers with a pretty significant customer profile for their customers. That office we would hope someday would have 100 to 125 customers that it serves -- very high-end customers, including folks that you would find in the top 10 nationally in development categories of different kinds. And that office has been the largest contributor of our loan growth this year.

The second strategy is what we call the metro Dallas strategy and it is really a more traditional retail banking operation. We have two offices, now both in Frisco, Texas that will fulfill the strategy and it is a strategy to do in the metro Dallas area, in that nine, 10, 11 county area, essentially what we’ve done in Arkansas in the past, and that’s to have a really active lending and deposit retail bank that has a significant commercial book-of-business associated with it and generates trust prospects and cash management customers and all of that.

And then the third strategy for Texas is more of a mid-market strategy. We’re in Texarkana, Texas and Texarkana look a lot like Harrison, Arkansas or Fort Smith, Arkansas as far as its economic profile. We’ve got a great guy that leads that. We’ve got great guys leading all three of these units for us and our expectation is that in probably 2009 or 2010, we will expand into another Texas city in east Texas from that office and that those guys will develop over time a pretty significant network of offices in the second-tier Texas cities, below your Dallas, Houston, San Antonio, Austin type markets and your second-tier Texas markets, much as we have in many of the top 20 cities in Arkansas.

So we are approaching it from all three of those directions and we think all three of those strategies are going to serve us very well. They are all off to wonderful starts and we’ve been a couple of years in Texarkana, three years on Frisco, and I guess three or four years now with real estate specialties group and those are all developing very well. We’ve sort of ramped them up slowly and really made sure we understood what we were doing and that everybody was on the same page and I think they are poised for fairly significant growth.

As a result, we believe that Texas will contribute a disproportionately large percentage of our company’s growth going forward. Now, we still have some Arkansas offices to open but as we commented in the first quarter when we made a decision to not open an office in Jacksonville, Arkansas and sold that site and entered into an agreement to settle the longstanding dispute regarding that branch application. In Jacksonville, we made the comment I believe that part of our decision there as we looked at our opportunities in Texas, we saw those as better than the opportunities for that Jacksonville office and as a result decided to abandon that effort and we booked a pretty nice little gain associated with abandoning that effort, in preference for being able to open another office more quickly in Texas.

We continue to evaluate that on an ongoing basis and there may be one or two or three more Arkansas sites that as time goes on we elect to sell, part of our mindset for that decision could very well be that we continue to think gosh, relative to what we might do with a new Texas office, that one might not do as well as one in Texas.

So we are constantly evaluating that and our experience in Texas has been so good that we are just very encouraged about our prospects there for the future.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Okay, I appreciate the color. Just a couple of other questions here; the variable rate versus fixed rate loans, can you give the breakdown at quarter end?

George Gleason

Yes, at the end of the quarter, 48.99%, so we’ll just round that off to 49% of our loans were variable rate loans. That is up several percentage points, I think about four or five percentage points from the prior quarter and that again is a function of the fact that most of our growth in the third quarter came from Texas because we find it much easier to get variable rate loans in Texas. In Arkansas, there’s just a strong customer desire to have fixed rate loans.

The growth in Texas is also tending to accelerate the growth in the variable rate parts of our portfolio.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Could you comment about the percentage of loans that are tied directly to prime, especially given the fed rate cut here?

George Gleason

I don’t have that number handy. We’ll try to put that in the Q or something and give you that number, but the majority of our loans historically have been tied to prime rate as an index, which of course is unfortunate that they weren’t all tied to libor, given what has happened to the spread between libor and prime recently.

But in our Texas portfolio, for example, a lot of our loans there, and I would say a growing percentage of our Arkansas loans are becoming libor-based credits but right now, the preponderance of those loans that are variable are tied to prime rate, so as a result, we incurred a 50 basis point reduction in the yield on those loans and that, since our CDs are fixed rate, we’ll have to well over CDs some period of weeks to offset that reduction in that prime rate. It will take a little while to catch up with that.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Okay, and just the last thing, the CNI balance at quarter end, do you have that?

George Gleason

Yes, I do. The CNI portfolio at quarter end was 9.5% of the loan portfolio, down from 9.8% as of June 30. Now that was essentially unchanged in dollars. We were down $400,000 from $172 million to $171.6 million in the CNI book in the quarter, but because of the growth in the real estate side of the portfolio that the CNI piece went down percentage terms by three-tenths of a percent.

Total real estate loans at quarter end were 81.5% of our portfolio, compared to 81.0% at June 30 and 81.6% at the end of last year.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

And maybe one last thing, if you have it; you talked about the broker CDs in the quarter. Could you just give what level you are at there? And then you talked about I guess maintaining some type of reasonable level there. Can you define or just give a little color on what you view as reasonable? And I’ll hang up and I appreciate your help.

George Gleason

All right, very good. Let me see if I can get you that information: total brokerage CDs at September 30 were $253 million and to give you a comparison, at June 30, that number was $356 million. So a $103 million reduction in brokered CDs during the quarter.

And as far as what constitutes reasonable, certainly we were not uncomfortable at all at the $356 million level and I actually wouldn’t be uncomfortable at a level higher than $356 million, so I don’t think that’s a significant constraint on us.

And really, when I said within reasonable limits, what I was really referring to principally was borrowing and we have a policy that we will use our federal home loan borrowing capabilities up to a high level. We wouldn’t mind $300-and-something million or so borrowed from the federal home loan bank, but we have a policy of always keeping a $75 million cushion on those borrowings. We always want to have at least $75 million more federal home loan borrowing capacity than we have utilized at any time, plus we always want to have our full, federal reserve discount, primary credit borrowing capability intact and we maintain a number of fed funds lines of credit that we also want to have intact.

So the limitations are there is we have a number of internal guidelines on secondary sources of liquidity that we want to maintain at all times for emergency purposes and subject to those limitations, we would continue to increase borrowings and brokered deposits.

Brian Martin - Howe Barnes Hoefer & Arnett Inc.

Okay, thanks very much, George.

Operator

Your next question comes from the line of Andy Stapp.

Andy Stapp - B. Riley & Company, Inc.

Yeah, I just have one other question, if you could just provide the duration of your securities portfolio at September 30?

George Gleason

Modified duration of the securities portfolio at September 30 as estimated by our accounting provider for that FTN Financial was 5.31 years.

Andy Stapp - B. Riley & Company, Inc.

Okay, great. That’s all I have. Thank you.

Operator

Your next question comes from the line of David Bishop.

David Bishop - Stifel Nicolaus

George, one follow-up, circling back to Texas: in terms of expansion there, is the cost of acquiring commercial lending talent there still relatively prohibitive and has that raised any hurdles in terms of is that impeding your growth there or are you sort of happy with the trajectory you are projecting here in terms of your ability to grow there over the future?

George Gleason

Well, talent is not cheap there but I wouldn’t characterize the cost of it as prohibitive. In fact, we added another really high quality lender, a very experienced high level guy that we picked up from another bank on Monday of this week, so -- and we are very excited about that and he is already having some significant conversations with some very desirable new lending prospects, so we are very optimistic about that.

Certainly, as I’ve said a number of times, the key to our company’s future success is being able to continue to add the talent of the nature and volume that we’ve been able to add talent in the past, and it is always a challenge in every market to find the right guys and then to hire those guys, and we’ve had a good track record of doing that. We are encouraged with the three teams that we have in place in the various Texas markets now. We are encouraged by the leadership of those teams and the growth and potential, and capabilities of those guys.

We are feeling pretty good about it. Certainly we are always looking for talent and we just have to continue to always look for talent and add good talent wherever we can find it, whenever we can find it.

David Bishop - Stifel Nicolaus

Great. Thank you.

Operator

At this time, sir, there are no further questions.

George Gleason

All right. There being no further questions, let me thank all of you for joining the call today and tell you we look forward to talking with you in about 90 days and we’ll see you then. Thanks very much. Have a good day.

Operator

That concludes today’s conference call. You may now disconnect.

Copyright policy: All transcripts on this site are copyright Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.