Executives
Leslie Loyet - IR
Lynn Fuller - President and CEO
John Schmidt - COO and CFO
Analysts
Jeff Davis - FTN Midwest Securities
Brad Milsaps - Sandler O'Neill
Jon Arfstrom - RBC Capital Markets
Brian Martin - Howe Barnes
Presentation
Heartland Financial USA Inc. (HTLF) Q3 2007 Earnings Call October 29, 2007 4:00 PM ET
Operator
Good afternoon, ladies and gentlemen, and thank you for standing by. Welcome to the Heartland Financial USA Third Quarter 2007 Conference Call. During today's presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions. (Operator Instructions). This conference is being recorded today, October 29, 2007.
I would now like to turn the conference over to Leslie Loyet, from Financial Relations Board. Please go ahead.
Leslie Loyet
Thank you. Good afternoon, everyone. Thank you for joining us for Heartland Financial USA's conference call to discuss third quarter results. This morning, we distributed a copy of the price release, and hopefully you've all had a chance to review the results. If there is anyone online who did not receive a copy, you may access it at Heartland's website at www.htlf.com, or you may call Han Huie at 312 640 6688, and she will send you a copy immediately.
With us today from management are Lynn B. Fuller, President and Chief Executive Officer, and John K. Schmidt, Chief Operating Officer and Chief Financial Officer. Management will provide a brief summary of the quarter and then we will open the call up to your questions.
Before we begin the presentation, I would like to remind everyone that some of the information that management will be providing today falls under the guidelines of forward-looking statements as defined by the Securities and Exchange Commission. As part of these guidelines, I must point out that any statements made during this presentation regarding the company's hopes, beliefs, expectations or predictions of the future are forward-looking statements, and actual results could differ materially from those projected.
Additional information on these factors is included from time to time in the company's 10-K and 10-Q filings, which can be obtained on the company's website or the SEC's website.
At this time, I would like to turn the call over to Lynn Fuller. Please go ahead.
Lynn Fuller
Thank you, Leslie, and good afternoon everyone. We certainly appreciate everyone joining us this afternoon; I assume you all have had an opportunity to review Heartland's third quarter earnings release that was issued this morning.
Today, Heartland reported year-to-date 2007 earnings of $18.9 million, or 7.5% over the previous year, and third quarter earnings of $6.9 million, matching last year's quarter. Diluted earnings per share are $1.14 year-to-date compared to $1.05 last year. So a nice increase in EPS year-to-date, and $0.42 for the third quarter, compared with $0.41 for the previous year's quarter.
Let's start out with the positives, as several areas of our performance stand out as positives. First, earnings from continuing operations are up year-to-date and quarter-over-quarter. Second, non-interest income continues to show very good increases, growing 6% for the quarter and 10% year-to-date.
Next, non-interest expense continues to moderate, growing by only 8% over last year despite the opening of five new banking locations. And finally, loan and deposit balances are both showing good growth increasing by 8% and 6%, respectively, on an annualized basis.
Now, these positive earnings and growth performance highlights are tempered to some degree by a decrease in our net interest margin and an increase in our nonperforming loans, which grew from $19 million to $30 million during the quarter. This increase is primarily in four credits, of which one has already been brought current and back on accrual. We believe the slowing economy has, at least in part, contributed to this increase in nonperformers.
During our second quarter conference call, we described some softness in our Wisconsin markets, where nearly half of our nonperforming loans reside. You may also recall that during the second quarter we had substantial provision expense in anticipation of probable losses in these credits; as a result, this quarter's provision expense is down substantially, as we believe we are adequately reserved.
John Schmidt, Heartland's CFO and Chief Operating Officer, will provide further color on our financial results in a few minutes. But first, I would like to describe some of our recent expansion activities.
In September, Rocky Mountain Bank opened a second office in Billings, Montana to take advantage of expected growth in the city's west side. Just last week, Arizona Bank & Trust opened its sixth location in the Southeast Valley of Phoenix with an office in Gilbert. This is another burgeoning community that offers exceptional opportunity for both our business and retail banking lines.
In Colorado, Summit Bank & Trust is putting the finishing touches on a new office in the community of Erie with an opening planned for next week. This location was recently purchased from another financial institution and provides an excellent opportunity to take another step forward in rounding out our Northern Front Range presence in the Denver market with three banking locations.
For some time now, we've expressed an interest in chartering a new bank in Minneapolis, Minnesota. This Midwest market provides exceptional growth dynamics and is dominated by large regional and national banks, a market environment we find attractive. Heartland has joined with the local investor group who will own 20% of the bank. The bank will be capitalized at $16 million. Kate Kelly, an experienced and visible local banker, will serve as President of Minnesota Bank & Trust, Heartland's tenth bank.
We are excited about the prospects of competing in the Twin Cities market and are planning to ramp-up our presence with a loan production office in Edina, the location of the bank's proposed main office. Our goal is to open Minnesota Bank & Trust in the first quarter of next year.
With the opening of Minnesota's LPO late this year, Heartland's footprint will expand to eight states with 60 banking offices serving 41 communities. At this juncture, our branch expansion plans for next year are to construct three new offices, down from five additions this year, one in New Mexico, one in Arizona, and a second location in the Minneapolis area.
Looking ahead to the fourth quarter and beyond to 2008, our four top corporate objectives are: number one, same-store growth of core deposits and quality loans; number two, a mandate to cleanup nonperforming loans, cutting our nonaccruals in half; three, managing our net interest margin; and four, controlling non-interest expense through the implementation of workplace lean, a product of Six Sigma, an initiative to streamline processes and eliminate redundancies, which we believe will reduce cost while improving service to our valued customers.
Well, that concludes my comments. I will now turn the call into John Schmidt for more detail on our third quarter and year-to-date financial results. John?
John Schmidt
Thanks, Lynn, and good afternoon. As in the past, I will provide additional details on this morning's press release. Emphasis will be given to the most substantial changes to our balance sheet and income statement in the past quarter, 9/30/07 versus 6/30/07.
Looking first at the balance sheet, loan balances decreased by $24.1 million in the third quarter as the availability of quality new loans have been reduced at this point in the credit cycle. Additionally, the time our lenders spend collecting nonperforming assets also impacts production. At the same time, year-to-date loan growth stands at $98 million and $119 million when those loans sold at the Broadus, Montana location are included.
Looking ahead, it is likely that we will be moving $16 million to $20 million of underperforming, although still accruing, credits out of the organization in the fourth quarter. Additionally, early in the fourth quarter, we entered into an agreement to sell $6 million of portfolio loans. As a result, we are scaling back our forecasted annual loan growth to $110 million for the year ended 12/31/07. This number excludes $28 million of loans moved from available for sale in the portfolio as of 6/30/07.
Net charge-offs for the quarter totaled $1.9 million and $5.2 million from a year-to-date perspective. Total net charge-offs to date, expressed as a percentage of average loans and leases, totaled 23 basis points. We feel we should see a moderation in the amount of charge-offs for the balance of 2007.
Relative to nonperforming loans of this quarter's increase, a third of the dollars have returned to accrual status. You'll also recall from last quarter that $4 million of the total nonperforming loans were loans that were guaranteed by the USDA and SBA and previously sold to the secondary market and then subsequently repurchased. While we're very focused on resolving our nonperforming credit issues, given that some of these nonaccrual loans are real estate loans, they will take longer to work out of our system.
Finally, I'd like to point out that our allowance for loan loss methodology remains consistent with previous quarters.
Moving to core deposits, core deposits, excluding brokered CDs in this case, grew $57 million for the third quarter, representing an annualized growth rate of 10%. While deposit growth is typically stronger in the third quarter this reflects one of our key strengths of our organization. We continue to view the growth of our deposit base as a focus for all of our sales personnel, both loan and deposits.
As Lynn mentioned, net income totaled $0.42 per basic and diluted share. The approximately $0.01 dilution we've experienced for the past several quarters has been effectively eliminated as management found a decrease in stock price to be an opportunity to exercise stock options.
The company's net interest margin was 3.87 for the quarter, which is a 15 basis point decrease from the quarter ended 6/30/07. During the last conference call, we forecasted that our margin would drop to 3.95%. The 8 basis point differential between the expected amount and our actual results can be explained by the following factors: one, loans being placed in nonaccrual status impacted margin by 4 basis points; the reduction of $24 million in loans with a margin impacted by the difference between the rate earned on loans and Fed funds added an additional 2 basis points.
Finally, the addition of $20 million in bank-owned life insurance mentioned last quarter, the funding of which impacts interest expense while the corresponding earnings are reflected in non-interest income, contributed an additional 2 basis points, arriving at the 8 basis points that I mentioned.
Going forward with the opportunity to reprice about 77% of our CD portfolio in the next year at rates slightly lower than the current 4.87%, we see a relative stabilization of the margin. At the same time, we do remain asset sensitive, thus, an additional Fed rate cut would have a negative impact on our margin.
Non-interest income continues to reflect solid improvement over last year and consistent strength versus last quarter results. The most notable change was the impact of the previously mentioned increase in the amount of bank-owned life insurance on our books. This increase combined with a higher return on the underlying policies, contributed $278,000 to the increase in non-interest income for the quarter. The previously mentioned sale of $6 million of portfolio loans should result in a gain of approximately $1 million, which will be reflected in the fourth quarter.
We were also very pleased with the continued stabilization of non-interest expense, which ended the quarter at $24.7 million, $182,000 or 1% decrease from the second quarter. Even considering the cost to ramp up Minnesota Bank & Trust, we expect that expenses will remain relatively flat during the fourth quarter.
With that I will open up for questions.
Question-and-Answer Session
Operator
Ladies and gentlemen, at this time we will begin the question-and-answer session. (Operator Instructions). Our first question comes from the line of Jeff Davis with FTN Midwest Securities. Please go ahead.
Jeff Davis - FTN Midwest Securities
Good afternoon. John or Larry, if I can get you to comment on perspective on performance of the individual subsidiaries what was -- who was strong, who wasn't, and maybe looking forward, and why? And then secondly, John, the $1 million gain for the fourth quarter, is that likely to be offset by elevated expenses or one-time items?
Lynn Fuller
Jeff, this is Lynn. The Western banks of New Mexico Bank & Trust in Montana are showing very good performance. The other two banks south west, Arizona and Denver, are close to their budgets, a bit under at this point, but both are still in their first five years of operation de novo banks. So, we've been expanding them rather aggressively, as I shared with you. Dubuque continues to be a solid performer, albeit a bit behind where they were last year. The banks that are struggling this year would be: Wisconsin, Riverside, and Rockford and Galena had that one-off lost that hit us last quarter. And John I don't know if you've got more to add to that.
John Schmidt
No, that's a pretty good summation. I think the other one, First Community in Keokuk, Jeff, remains, actually it was one of the top performers in the group. And just to add color on Galena, aside from that one loss, their performance is very much -- they are very solid, consistent with last year, let me put it that way.
Relative to your second question, the costs anticipated on the conversion of that portfolio is right around about $200,000.
Jeff Davis - FTN Midwest Securities
Okay, thank you.
Operator
(Operator Instructions). Our next question comes from the line of Brad Milsaps with Sandler O'Neill.
Brad Milsaps - Sandler O'Neill
Hi, good afternoon.
Lynn Fuller
Hi Brad.
Brad Milsaps - Sandler O'Neill
Just to follow up to Jeff's question in terms of the individual banks, I think last year, initially the de novo in Colorado lost about $1.2 million in the fourth quarter. Is it your sense that you'll be able to get Minneapolis off the ground maybe a little bit better than that or is that a pretty good blueprint for us to look at in terms of how Minneapolis, at least, is going to play out in the near-term?
John Schmidt
You know, Brad, I think we still look at the de novo model that we put in place, given the ramp up in personnel and having quality people in place. We look to have a $1 million loss in that first year, not necessarily, I think you said quarter, but the first year loss will be a run of about $1 million, if not just a little bit north of that. So again, that's the way we've built them historically. I think it's having the quality people on the ground first. Certainly, we would like to see a ramp up and portfolio maybe a little bit faster but that's what we would anticipate from Minnesota Bank & Trust.
Brad Milsaps - Sandler O'Neill
Okay, fair enough. Thank you.
Operator
Your next question comes from the line of [Shawn Collins] with RBC Capital Markets.
Jon Arfstrom - RBC Capital Markets
Hi guys, its Jon Arfstrom.
Lynn Fuller
Hi Jon.
Jon Arfstrom - RBC Capital Markets
Hi. A couple of questions for you. The securities growth that was up a little more than we expected, John, just curious what the appetite is there?
John Schmidt
No, I think the -- certainly the reduction of the loan balances Jon that was an opportunity that we saw to move into the securities area. Certainly, there was a sell-off in some sectors of the market or the bond market as a whole, which we took advantage of. I think we were very pleased with what we were able to roll into on the securities side.
Jon Arfstrom - RBC Capital Markets
All right. And then can you talk a little bit about the components of the nonperformers in terms of the size of the credits that are in there and the types?
John Schmidt
You know, I think last quarter we talked about one large credit, certainly, in Wisconsin; it was about $7 million. I would say as a rough estimate maybe from a macro perspective, Jon, we could say, of the $30 million that could be accounted for in eight credits or so, kind of back on napkin approach, but it isn't a huge number of credits. Rather, it's just fairly contained in, as I said, eight credits of any real size.
Lynn Fuller
A common thread that runs through those credits, Jon, is that, for the most part, they are backed up with pretty good low LTVs on the real estate. That's why it's going to take us some time to work through them. We have got some condo projects in Wisconsin. We had one large credit that we talked about last quarter in Galena that was not backed by real estate, but for the most part, we've done a good job of taking collateral. We think we are in the assets right. It's just going to take us some time to foreclose them out or move them out.
Jon Arfstrom - RBC Capital Markets
Fair enough.
John Schmidt
Jon, just a little more color, seven of the -- there are seven credits over $1 million in that $30 million total, one credit alone that was just added was $5 million.
John Arfstrom - RBC Capital Markets
All right, good. That's helpful. A little bit on the loan pipeline -- can you talk about how that feels, and then your comments about a little bit slower loan growth? I think we all understand it. How much of it would you say is the market that you're in generally being slower, and how much of it is your own cautiousness?
John Schmidt
I think that the first thing would be probably the markets we are in. We aren't seeing the number of deals, good deals that we want to pursue as we had in the past. I think this is totally reflective of the economy. Certainly, we're cautious, but I don't think we are overly cautious at this point. We are still willing to do good deals. I think the fourth quarter is we're moving some credits out; we're putting together budgets for '08 now. We still look to have reasonable loan growth for '08. It's still always unknown being what's going to happen to the economy and how far it will swing.
John Arfstrom - RBC Capital Markets
And I guess the last question is fourth quarter of '06, you had some payouts in your loan portfolio if you go back through the notes, and I'm just curious what your outlook is in terms of that type of activity at the end of the year. Is that just something we should naturally expect?
John Schmidt
The first thing that comes to mind is certainly the Ag portfolio. I think we are in a stream of about $5.4 million reduction in the Ag portfolio in Q4. The Ag sector I think remains pretty darn strong at this point. Other than that, I mentioned $16 million to $20 million of loans that we are moving out. Those are loans we do want to move out. They are currently on accrual. I want to make sure everybody understands it. They aren't in that $30 million total, but they are an additional $16 million to $20 million of loans we'll be moving out. So, I still forecast loan growth in Q4 certainly not as robust as it's been but understand the offsets.
Lynn Fuller
John, I would say I would characterize 2007 as a year that we have aggressively moved some credits out that were refinanced at other financials. We've also seen normal pay downs on a fair number of credits.
So, the production that we've had has been reasonable, but we've had to replace a lot of credits that were either moved out or credits that were just normally paid off.
John Arfstrom - RBC Capital Markets
Okay, thank you.
Operator
(Operator Instructions) Our next question comes from the line of Brian Martin with Howe Barnes.
Brian Martin - Howe Barnes
Hi, guys.
Lynn Fuller
Hi Brian.
Brian Martin - Howe Barnes
John, can you just give a little color? Your residential development exposure, how big is that?
John Schmidt
Residential development loan, Brian?
Brian Martin - Howe Barnes
Right.
John Schmidt
I don't have that figure right now, but if I had to guess, it would be in the $50 million to $70 million range.
Brian Martin - Howe Barnes
Okay, and most of that being in the Midwest, or more out West?
John Schmidt
Probably more out West than in Midwest.
Brian Martin - Howe Barnes
And net portfolio, is it performing pretty well at this point?
John Schmidt
Yes, I think by and large. We don't have any non --
Lynn Fuller
We have one credit, one credit in Montana that is a residential development, but other than that, the rest of them are all doing well. They are still performing; that's a performing asset.
John Schmidt
I don't think we have any residential developments right now, Brian that are non-performing.
Brian Martin - Howe Barnes
Okay. All right, how about, the tax rate? What is a good level to be using as we go forward here, given some of the things that have impacted it this year? Can you --
John Schmidt
Yes, I see and as you saw in the release, certainly the purchase of those credits kind of makes it a little difficult to track exactly where the marginal tax rate is, if I call it that. I still think, if you use 31.5%, 32%, you're probably in a decent range on that.
Brian Martin - Howe Barnes
Alright, and lastly, Lynn talked a little bit about his four objectives for next year. Can you just talk a little bit about the expense line item or the expense objective and kind of what your thoughts are -- what your expectations are there -- kind of what you're planning in on doing there?
Lynn Fuller
As far as the implementation of workplace lean and other initiatives?
Brian Martin - Howe Barnes
Exactly.
Lynn Fuller
We don't have a hard number, we're going through the budgets right now. But the obvious is that if we can't grow our earnings base at the level we would like to, and if margins shrink, the only place left to look is in overheads. So, if it means we will have to address salaries and our variable expense on bonuses, we will go there. Otherwise, we will have a number of initiatives underway next year which will be part of our budget, and I just don't have the numbers for you on those yet, Brian. But there will be a number of initiatives that will be underway with workplace lean.
Brian Martin - Howe Barnes
Okay. I guess, if you can't get the growth in what you're looking for, it won't prevent you from opening the office that you are shooting for. I mean, it would be other items outside of that, correct?
Lynn Fuller
Yes. Well, as I said, we've only got three new offices planned for next year, compared to the five we opened this year. The last three years, we've had pretty aggressive branch openings. So that's going to be trimmed back a bit, and we are hoping to get some cost savings out of workplace lean.
John Schmidt
Brian, it is not that this is certainly a knee-jerk reaction to any –
Brian Martin - Howe Barnes
Right, no, I didn’t [inaudible]
John Schmidt
So, we've been working through and getting ready for workplace lean, as Lynn described for quite awhile. So this is just the next step in that, and it seems to coincide very well with where we are in our stage of evolution.
Brian Martin - Howe Barnes
Alright, I understand. Okay, thanks guys.
John Schmidt
Thanks.
Operator
Mr. Fuller, there are no further questions at this time. Please continue with any closing remarks.
Lynn Fuller
Very good. Thank you. I guess, in summary, Heartland's financial performance remains solid with continued EPS growth, and that's an objective that we will continue to focus on. We've had decent balance sheet growth and solid noninterest income growth and a leveling off of non-interest expense. As I said, we will be working on some projects with workplace lean to continue to control our non-interest expense. I want to thank everyone for joining us today and hopefully, you can join us again for our next quarterly conference call, which will be January 28 of next year. Thanks again. Have a good evening.
Operator
Ladies and gentlemen, this concludes the Heartland Financial USA third quarter 2007 conference call. Thank you for your participation. Thank you for using ACT Teleconferencing. You may now disconnect. Have a pleasant day.
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