Heartland Financial USA, Inc. Q2 2008 Earnings Call Transcript

Jul.28.08 | About: Heartland Financial (HTLF)

Heartland Financial USA Inc. (NASDAQ:HTLF)

Q2 2008 Earnings Call

July 28, 2008 4:00 pm ET

Executives

Leslie Loyet - IR, Financial Relations Board

Lynn Fuller - President and CEO

John Schmidt - COO and CFO

Ken Erickson - EVP and CCO

Analysts

John Rowan - Sidoti & Company

Brad Milsaps - Sandler O'Neill

Jeff Davis - FTN Midwest Securities

Brian Martin - Howe Barnes Hoefer & Arnett

Operator

Good afternoon, ladies and gentlemen, thank you for standing by. Welcome to the Heartland Financial USA, second quarter 2008 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 call is recorded today, Monday, July 28th of 2008.

I would now like to turn the conference over to Leslie Loyet with Financial Relations Board. Please go ahead.

Leslie Loyet

Thank you. Good afternoon everyone. Thank you for joining us for the Heartland Financial USA conference call to discuss second quarter 2008 results. This morning, we distributed a copy of the press 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 Hoi] at 312-640-6688 and she will send you a copy immediately.

With us today from management are Lynn Fuller, President and Chief Executive Officer; John Schmidt, Chief Operating Officer and Chief Financial Officer; and Ken Erickson, Executive Vice President and Chief Credit Officer.

Management will provide a brief summary of the quarter and then open the call up to your questions.

But 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.

With that said, I'd now 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 today as we review Heartland's performance for the second quarter of 2008. I hope you all had an opportunity to review Heartland's earnings release that we issued this morning.

For the next few minutes, I'll touch on the highlights of our financial performance and ongoing growth strategy. And then I'll turn the call over to John Schmidt, our Chief Operating Officer and CFO; and Ken Erickson, our EVP and Chief Credit Officer, who will provide additional details on Heartland's second quarter and year-to-date financial results.

In today's earnings release, Heartland reported income from continuing operations of $4.7 million or about 1.4% increase over the previous year. Year-to-date income from continuing operations is $11 million, compared to $10.3 million last year, and that's a 6.7% increase. You may recall that last year's second quarter earnings included a $2.4 million pre-tax gain from the sale of our Rocky Mountain Bank's Broadus branch.

Using continuing operations as our reference point, diluted earnings per share for the second quarter were $0.29 compared to $0.28 last year, and $0.67 year-to-date compared to $0.62 for the previous year. Although, we fell a bit shy of our earnings expectations, we were pleased to maintain increases in earnings per share from continuing operations over comparable periods.

Well this is clearly the most difficult banking environment we have seen in years, and like most banks, Heartland is challenged by the effects of higher loan loss provisions and increased nonperforming loans. Achieving a substantial reduction in nonperforming loans is Heartland's top objective for 2008 and we expect to see improvement by the end of this year.

In a few minutes, Ken Erickson, our EVP and Chief Credit Officer, will provide more detail on the credit side.

The bright spot in Heartland's second quarter performance, and in fact over the past four quarters, is the maintenance of our net interest margin. We saw a slight expansion in margin for the quarter up to 3.92%, with many of our peers' margins going the opposite direction. I believe this is a good indication of Heartland's underlying earnings power. Our stated goal this year is to maintain margin at or above the 2007 year end mark, which was 3.87%.

To date, our pricing discipline and pricing strategies have produced the desired results. Additionally, achievement of our number one priority this year, that is the reduction of nonperforming loans, should have a positive effect on margin going forward. We were pleased to see non-interest income increase by 7% and non-interest expense only increase by 4% over the same period last year. Part of the increase in non-interest expense can be attributed to the opening of six new banking offices last year, and this year's opening of our newest de novo charter, Minnesota Bank & Trust.

I can assure you that expense management continues to be one of our top six objectives for the year, as we work to identify cost savings in every area of our operation, and initiate workplace lean projects throughout the company.

With respect to the balance sheet, we are experiencing slower growth during the first half of the year. Since year end 2007, we've seen annualized growth rates in loans of 1%, deposits of 3% and assets of 7%.

In that light, generation of core non-maturity deposits, that's checking and savings deposits, is a key objective for 2008. We've been very careful not to overpay for these deposits, in an effort to maintain our net interest margin, which is also one of this year's key objectives.

We have enjoyed a 9% growth in savings deposits from the introduction of a new business, money market sweep account. And on the retail side, our Cash Rewards checking product has been met with tremendous success, attracting over 3000 new accounts to-date.

In terms of Heartland's expansion plans, we have intentionally slowed the pace of new branch office openings for 2008. We only have one additional office to open this year, New Mexico Bank & Trust will open its 17th banking location late this year, in Albuquerque, New Mexico.

Given the problems in the banking industry, we are beginning to see acquisition opportunities that we believe finally make sense. As a result, we have changed our strategic growth initiatives from de novo banks and branching to acquisitions. We like the markets that we are currently in, and will focus our attention on fill in acquisitions, where we can grow market share, achieve efficiencies and provide greater convenience to our current clients. Additionally, we have asked our regulators to notify us, when troubled institutions surface in our current markets.

In my previous comments this afternoon, I touched on four of our six key performance objectives for this year. The final two are; a continued emphasis on training, especially for our salespeople and supervisors. We continue to invest heavily in our greatest asset, our employees, and a leadership discipline, which holds management accountable for achievement of our plans and budgets.

Given the state of our industry, with a number of banks cutting their dividends, I thought it might be helpful to share with you that earlier this month, Heartland's Board of Directors held our dividend unchanged at $0.10 per common share payable on September 12, 2008.

Well, that concludes my comments. I'll now turn the call over to John Schmidt for more detail on our second quarter and year-to-date financial results, and then John will introduce Ken Erickson, who will provide additional color on credit quality and real estate exposures in our major markets. John?

John Schmidt

Thanks Lynn and good afternoon. As in the past, my comments will again focus on the most substantial changes, Heartland's balance sheet and income statement in the past quarter, 6/30/08 versus 3/31/08.

Looking first at the balance sheet. Total loan balances increased by $23.7 million in the second quarter. $12.4 million of this increase was in the commercial and commercial real estate category, primarily at Dubuque Bank and Trust and Summit Bank & Trust. While loan growth has been sluggish in the first half of the year, we are starting to see our pipelines expand. As a result, despite the ongoing efforts to cleanup non-performing loans, we would still adhere to our previous estimate of $100 million in loan growth by year-end 2008.

Total assets increased by $78.6 million in the second quarter, primarily as a result of the implementation of a $50 million leverage transaction. This investment portfolio strategy was funded with a combination of wholesale funding and short-term borrowings.

Core deposits, meaning excluding brokered CDs decreased slightly by $2.1 million from a quarter-over-quarter perspective. We are pleased with the growth in our savings and interest bearing checking price, which increased by $31 million in the second quarter. This increase was offset by the decrease of $38.6 million in time deposits, excluding brokered CDs.

Competition for deposits continues to be keen, and as a result, we found the Federal Home Loan Bank to be a lower cost funding alternative with balances increasing by $36.3 million in the past quarter.

Moving on to the income statement, as Lynn mentioned net income totaled $0.29 per basic and diluted share. What significant in this is the fact that we increased our margin to 3.92% for the quarter. We are able to accomplish this by aggressively moving funding rates down in light of the Federal Reserve cuts in the first quarter. Included in this was a continued down re-pricing of our trusts preferred securities.

Of the $110 million currently outstanding, $65 million re-prices with LIBOR. Currently our all in rate for all of our trusts preferred securities is 5.99%. Another contributor has been the interest rate floors, which were purchased in anticipation of a lower rate environment. At current levels, these vehicles contributed 2 basis points to the margin during the quarter.

Going forward, we would model our margin in the 3.80% to 3.85% range, which will certainly be impacted by our ability to grow loans and the overall level of nonperforming loans. We see little additional benefit coming from the re-pricing of our CD portfolio with $826 million maturing in the next year at 3.79%, which very closely approximate current market rates.

The second quarter results were hampered by the $5.4 million provision expense as compared to $1.8 million recorded in the first quarter. Arizona Bank & Trust accounted for $2.8 million or 53% of the total with $2.3 million of the $2.8 million second quarter expense related to one credit.

Net charge-offs for the second quarter, totaled $4.1 million as compared to $1.1 million in the first quarter. $2 million of the $4.1 million was related to the same one credit at Arizona Bank & Trust. For the second quarter, net charge-offs of Arizona Bank & Trust represented $3.1 million or 76% of the $4.1 million total and Citizens Finance, our finance subsidiary accounted for 8% of the total.

Noninterest income was down by $156,000 on a linked quarter basis. Increases in security gains and service charges and fees were largely offset by the reduction in other noninterest income. Other noninterest income during the first quarter of 2008 included the $246,000 gain related to the Visa IPO and $198,000 mark-to-market gain on one of our outstanding derivative instruments. Total noninterest expense for the second quarter decreased by $326,000 or 1.3% from the first quarter levels despite the costs associated with the opening of the Minnesota Bank & Trust.

Salaries and benefits decreased slightly from the first quarter as the first quarter contained an annual payment of $284,000 for the executive life premiums. During the second quarter 2008, we also decreased our bonus accrual by $150,000 given our current financial performance levels.

Outside services increased by $138,000 primarily related to legal costs associated with the collection of our nonperforming loans. The $251,000 quarter-over-quarter increase in advertising relates primarily to promotions of focusing on core deposit generation and the opening of Minnesota Bank & Trust.

Minnesota Bank & Trust contributed a total of $518,000 in noninterest expense in the second quarter of 2008, as compared to $444,000 in the first quarter. As we indicated in the past, our de novo's typically lose between $1 million and $1.5 million on an after-tax basis in the first year of operation.

On a go forward basis, we don't forecast a significant increase in noninterest expense, given the moderation of branch openings that Lynn mentioned. Tax rate for the quarter was 25.89%, as tax-exempt income became a larger portion of the overall earning stream. On a go forward basis, we would expect our tax rate to be closer to 28% for the remainder of 2008.

In closing, it would appear that, excluding credit costs, that the core run rate of this company is very solid. As Lynn indicated, we remain committed in controlling these credit costs. With that, I'll turn it over to Ken Erickson, our Executive Vice President and Chief Credit Officer, who will provide additional detail on the loan portfolios. Ken?

Ken Erickson

Thanks, John. Good afternoon, everyone. As disclosed in our press release, our nonaccrual loans at June 30th were $43 million. This is an increase of $4 million from March 31st. This increase is primarily attributed to a $4.8 million commercial real estate transaction in Montana. Foreclosure has begun on that property.

We believe that the collateral we have on this loan should result in little or less NOR. Our nonperforming loans continued to be concentrated within a small number of credits. Six credits represent $26.9 million, or 63% of the nonaccrual loans. $3.4 million of the nonaccrual loan represents a government guaranteed portion of these loans. Of that $26.9 million represented by these six credits, $7 million is in lot development loans, and $7.5 million is in other residential real estate related industries.

Provision expense was $5.4 million for the second quarter. $2.3 million of this related to a single credit originated by Arizona Bank & Trust, due to the untimely death of the sole owner of a business in June and his company filing Chapter 11 bankruptcy shortly thereafter. A $6 million $450,000 loan to the company had been advanced in December 2007, primarily supported by a 50% loan-to-value on two parcels of land. Another $2 million loan had been granted for working capital.

The collectibility of the $2 million line of credit is thought to be significantly delayed due to this death and bankruptcy. As a result, the $2 million was charged-off, while a specific reserve was established through provision expense for the other loan. An additional $800,000 provision expense was taken to increase the specific reserve for a $7 million lot development loan in Arizona, as a new appraisal received during the second quarter, revealed a value significantly less than the prior appraisal on that property. The foreclosure of that property is expected to be completed in the third quarter.

Charge-offs, net of the $587,000 in recoveries were $5.2 million for the six months ended June 30th. The primary loss was the $2 million charge-off mentioned earlier. An additional $1.2 million of charge-offs were taken in Arizona on four residential lot loans. $695,000 of the charge-offs were taken at Citizens Finance, our consumer finance company, the remainder of the charge-offs were made up of a variety of smaller amounts across our banks, consumer, residential real estate and commercial loan portfolios. $3.4 million of our year-to-date net charge-offs were taken in Arizona. Arizona and Citizens represent 80% of the total net losses, while the remaining $1 million of losses are dispersed across the remaining banks.

In addition to the $7 million lot development loans, an additional $2 million in smaller nonperforming loans should have foreclosures completed in the third quarter. The fourth quarter should see the successful closure of an additional $11.4 million in existing nonperforming loans, reducing nonperforming loans to $22.6 million by year end, assuming no additional loans are moved to non-accrual status.

Other real estate increased by $2 million, to $4.2 million in the second quarter, as a result of our collection activity, and could rise to $17.5 million by year end. That assumes no sales of real estate that has been foreclosed. Through June 30th, net losses totaled $5 million, while provision expense was $7 million. Loan growth was only $14 million in the first six months, so the majority of the provision expense covered additional portfolio risk.

As mentioned earlier, a $2.3 million provision and $2 million charge-off were taken in the second quarter, as a result of the death and bankruptcy of the Arizona customer. Additional provision will also be required to cover loan growth realized in the second half. We anticipate provision expense to be at a reduced level for the remainder of 2008.

Loans secured by real estate totaled $1.8 billion, with commercial real estate at $1.3 billion. Within that, $384 million is secured by industrial manufacturing property. Commercial loans to contractors of residential real estate totaled $72 million, with $53 million of this amount representing presold homes. $45 million has been extended in land development and lot loans to commercial borrowers, while $41 million is extended for the purpose of land only.

Loans to individuals for residential construction loans and the purchase of residential lots sit at $42 million each. Loans to our largest 20 relationships aggregate $342 million, when including the amount available on their lines of credit. Only four of these relationships exceed $20 million individually, with the 20th on the list being at $11.3 million. Ten of these relationships have been originated by Dubuque Bank and Trust, five by Wisconsin, two by Rocky Mountain, and one each by Riverside, New Mexico and Arizona.

One of these 20 relationships is on our internal watch list representing $15.8 million. These 20 customers represent a broad range of industries, with only two in land and lot development, representing $27 million, and one in residential real estate construction for $14 million. $88 million of the $168 million consumer loans held by our banks are in HELOCs. In underwriting these loans, our policy guidelines allow us to advance up to 90% loan to value, if the customer qualifies for tier I classification, and if we have the first mortgage and are escrowing for both taxes and insurance. Otherwise HELOCs are established at 80% loan to value.

Our HELOC portfolio continues to perform well. Loans with payments more than 30 days delinquent represent 68 basis points of the HELOC portfolio, with only 21 basis points off accrual. Many of you have probably seen photos or news articles on the flooding in Iowa and other Midwestern states. As Heartland does not have banking establishments in the communities most heavily impacted by the floods, the floods have had very limited impact on our commercial loan portfolios.

Heartland banks have $240 million in agricultural credits, with 70% of this held by our Midwestern banks. Our ag portfolios continue to be well diversified between grains, dairy hogs and cattle, with approximately 30% being in grain production. Both flooding and the delays in planning the crops due to the cool wet spring will impact this year's profits to be realized by our agricultural customers.

Agricultural profits, as a result of the flood, are expected to be less than those realized in 2007, but will not have any significant negative impact on the industry or our portfolios. Citizens Finance, our consumer finance company, continues to show solid performance. Net loan growth is $2.3 million at six months, an annualized growth rate of over 11%, and net losses are 3.43% year-to-date down slightly from the first quarter.

With that I'll return the call back to Lynn.

Lynn Fuller

I think that's it. We can open up the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from the line of John Rowan with Sidoti & Company. Please go ahead.

John Rowan - Sidoti & Company

Good afternoon.

John Schmidt

Hey John.

John Rowan - Sidoti & Company

John, can you just go over your capital levels at some of the bank holding companies, specifically, the ones that have more asset quality problems, like Arizona Bank & Trust? Where are your regulatory capital levels, and how comfortable are you with those? And when was your last regulatory review?

John Schmidt

Generally speaking, John, we run all of our banks at minimum of 8%. Arizona, I think, right now is probably about 14%. We had capitalized them very heavily with the initial offering, and then, additionally, when we purchased an entity down there, approximately two years ago, we added additional equity there. So, Arizona, case in point I think, is very well capitalized. All of our entities, by and large, are well in excess of the regulatory guidelines.

John Rowan - Sidoti & Company

How about at the holding company?

John Schmidt

Holding company, again, as you see in the press release, we have risk-based capitals of approximately 12.5% right now. The tangible right now resides at about 5.5%.

John Rowan - Sidoti & Company

Okay. And when was your last regulatory review?

John Schmidt

In process right now.

John Rowan - Sidoti & Company

Okay. And can you give out the numbers on the nonperforming loans, and what you expect by the year end? I didn't get it all written down. Can you just go over that briefly?

John Schmidt

Sure. Let me turn that to Ken. John.

Ken Erickson

Let me turn back to my notes here. I mentioned that we have a $7 million lot development loan that should be resolved in the third quarter, as well as $2 million in other smaller nonperforming loans in the third quarter. And then in the fourth quarter, we expect $11.4 million of the current nonperforming loans to come to the end, through foreclosure processes most likely. That will take us from the $43 million that we're currently at, down to $22.6 million, and again that's based upon the numbers that are in there now, assuming no new dollars go into there.

John Rowan - Sidoti & Company

But that's going to then go into OREO, right?

Ken Erickson

Yeah.

John Rowan - Sidoti & Company

And you already have reserves against those, right? Assuming no further deterioration in collateral value, you are not going to take more charges as you move them down through OREO, correct?

Ken Erickson

As a general statement, yes. And that backs up the statement that provision expense should be lower throughout the balance of the year.

John Rowan - Sidoti & Company

Okay. Thank you very much.

Operator

Thank you. The next question comes from the line of Brad Milsaps with Sandler O'Neill. Please go ahead.

Brad Milsaps - Sandler O'Neill

Hey. Good afternoon.

Lynn Fuller

Good afternoon, Brad.

Brad Milsaps - Sandler O'Neill

Just a little more color on the CRE loan in Montana. Just curious, what part of the state that's coming out of, and just if you could, kind of, in general talk about the Montana market?

Ken Erickson

Okay. I don't want to talk specific about any credit, but we'll tell you that it's in Billings. But don't want to go into anymore detail than that on any specific loan. Montana seems to be doing okay. A little slowness in the absorption of land developments in the Bozeman area. But, all in all, we are seeing things to be relatively stable in the Montana market. Lynn, I'd ask if you want to add anything to that?

Lynn Fuller

I would concur with that, Ken. I think what I'm hearing, Brad, is that the activity has slowed. It was much more robust in '07, and we're seeing a slowing of activity, which is pretty much what we're seeing across the country. But in no case are we seeing the valuation decline that we've seen down in the Phoenix, Arizona area. Values seem to be holding up reasonably well. It's more of an absorption problem, just things are a little bit slower.

Brad Milsaps - Sandler O'Neill

And just curious if you guys could comment on, kind of watch list trends. I don't think you mentioned that in your comments, Ken. I certainly appreciate all the new detail, but just if you could comment on kind of watch list or 30-day past due trends?

Ken Erickson

Comparing June to March, total delinquencies for Heartland Banks, excluding the consumer finance company, were 3.62%, compared to 3.35% in March. I've mentioned a little bit about our HELOC portfolio, the delinquency there is 68 basis points, compared to 1.47%. The off-accruals are at 1.85%, compared to 1.69% in the prior quarter.

But when we looked at the individual credits, we did see some significant dollars move out of our nonperforming and watch list categories. Unfortunately, with the death and bankruptcy in Arizona, and this loan we talked about in Montana moving into a more serious classification, it negated all that we gained there, and fell backward by $4 million that we mentioned.

Brad Milsaps - Sandler O'Neill

Okay. And, John, maybe just a more question for you or Ken. If in Arizona, if you were to count up all the loans that they may have participated out to other banks within the system, what will their total loan portfolio look like, in terms of what you have in total exposure, just in that Arizona market?

John Schmidt

I think I looked at this at one point, Brad, fairly recently. It seemed to me that their total outstandings… Ken has it.

Ken Erickson

I've got it as a percentage of those loans that we would consider as a significant problem loan. On internal reports, I look at nonaccruals over $250,000, and our internal classification related to substandard over $500,000. We'd have 15% of their portfolio as originated on that list at this time, compared to our banks overall at 3.38%. So that takes in those larger loans, a couple of which are participated outside the member banks.

Brad Milsaps - Sandler O'Neill

So, 15% of the portfolio as originated in Arizona would be on some type of internal watch list or non-accrual?

Ken Erickson

Right.

Brad Milsaps - Sandler O'Neill

Okay. All right. Thank you very much. I'll step back.

Ken Erickson

Thanks, Brad.

Operator

(Operator Instructions). And our next question comes from the line of Jeff Davis with FTN Midwest Securities. Please go ahead.

Jeff Davis - FTN Midwest Securities

Good afternoon. John, it looks like from your call report and what I would see, the answer is no, but let me ask you an obituary question regarding the bond portfolio. Anything, we should be concerned of in terms of loss of market value or looking towards the year end impairment?

John Schmidt

I would say on the broad portfolio, no. I would suggest that we do have a $5 million piece of the Fannie Mae trust preferred. We don't see any impairment right now, but that is one thing we're keeping our eye on.

Jeff Davis - FTN Midwest Securities

Okay. And what about nonagency CMOs or MBS?

John Schmidt

We own some of those, Jeff. But we have done a tremendous amount of research on those. And we have seen maybe a little market depreciation in those. But by and large we're very comfortable with the overall status of those.

Jeff Davis - FTN Midwest Securities

Okay. Is that talk about $60 million?

John Schmidt

I think it's closer to probably $70 million right now.

Jeff Davis - FTN Midwest Securities

Okay. And in terms of any material amounts of pool trust preferred?

John Schmidt

None.

Jeff Davis - FTN Midwest Securities

Okay. Thank you.

Operator

Thank you. The next question comes from the line of Brian Martin with Howe Barnes. Please go ahead.

Brian Martin - Howe Barnes Hoefer & Arnett

Hey guys. Hey Ken, I couldn't write them down quick enough. You gave kind of the breakdown of the commercial portfolio. I hate to ask you to go back to your notes again, but the $1.8 billion and how you broke that up, can you run through that again real quick?

Ken Erickson

Sure. For the commercial real estate, first, with the total portfolio, we have $1.8 billion secured by real estate, and when I say that, that can include other collateral. We have most of our loans cross-collateralized to the operating entities. But below that $1.8 million, $1.3 million of that is commercial real estate.

And the largest components of that are: $384 million in industrial manufacturing property; loans to contractors of residential real estate $72 million, and of that $53 million are presold homes, $45 million in land development and lot loans; $41 million is land only. And then loans to individuals for residential construction loans, as well as their purchase of residential lots, are $42 million each.

Brian Martin - Howe Barnes Hoefer & Arnett

Okay. Thanks, Ken. Hey, John, just two questions on the fee income side. You gave the differential this quarter relative to last quarter, and is this a gain? And there was a mark-to-market adjustment. Was there any mark-to-market or anything this quarter that was in there, or is last quarter’s more the anomaly?

John Schmidt

I think last quarter's the anomaly and it actually may reverse slightly this quarter, Brian. So, (inaudible) in the same Q2

Brian Martin - Howe Barnes Hoefer & Arnett

Okay. And then just on the expense side, you talked about no change going forward, but just what were the differentials between first and second quarter? I thought you said you had some reversals of the bonus accruals this quarter, and then you had some additional expenses related to Summit. Can you just tell me?

John Schmidt

Yeah. Let me go just through that if I could real quick, Brian. Relative to salaries and benefits we did see a decrease in Q2. The Q1 contained a $284,000 payment for executive life premiums.

Brian Martin - Howe Barnes Hoefer & Arnett

That was in Q1 and Q2

John Schmidt

That was in Q1?

Brian Martin - Howe Barnes Hoefer & Arnett

Q1, okay.

John Schmidt

And that will occur, by and large, every Q1 on a go forward basis, and it will decrease slightly on a go forward basis. But we'll incur a charge every quarter, first quarter of every year, relative to the executive life premium.

Brian Martin - Howe Barnes Hoefer & Arnett

Okay.

John Schmidt

Additionally in Q2, then, we reduced our bonus accrual by $150,000, given the current performance levels.

Brian Martin - Howe Barnes Hoefer & Arnett

Okay.

John Schmidt

The flipping costs to the other way, they are not, it's [flipping] the other way. Outside services increased by $138,000, primarily related to legal costs, obviously associated with collection efforts.

Brian Martin - Howe Barnes Hoefer & Arnett

Okay.

John Schmidt

We did see a $0.25 million increase in advertising, as we again remained focused on growing our savings and demand deposit accounts. Additionally, the opening of Minnesota Bank & Trust impacted it. Finally, the thing I was identifying is that Minnesota Bank & Trust does have an ongoing cost and that is increasing as anticipated. In Q1, we incurred total non-interest expense of $444,000, Q2 that went to $518,000, all related to Minnesota Bank & Trust.

Brian Martin - Howe Barnes Hoefer & Arnett

Okay. So, about a $70,000 pick up.

John Schmidt

Yes, sir.

Brian Martin - Howe Barnes Hoefer & Arnett

Okay, all right. And just your comments on the acquisitions and fill in the acquisitions, the other branches you anticipated opening in your markets, are those all off the table at this point? And you feel that optimistic about getting acquisitions done, or can you just talk about in the last quarter, you mentioned a little bit, but you are more optimistic now than you were last quarter, and, if so, maybe what markets?

Lynn Fuller

Brian, this is Lynn. We haven't really taken any branch expansion plans off the table. We only had one branch, well, let me restate that. We opened Minnesota Bank & Trust in May of this year, so that was one additional planned opening for a location. And we had the New Mexico Bank & Trusts office in Albuquerque that was planned to open late this year.

There was one other branch in Arizona that we had the land acquired, but I don't believe we're going to be able to get it constructed and opened this year. It will probably flow into the first quarter of next year. So, that's all that we really had on the table as far as branch expansion.

And we really think that we're going to get opportunities to acquire at pricing levels that we can make accretive for our current shareholders, and that's a commitment we've had for some time, that we're not going to do dilutive transactions. So, I think our opportunity in the next 24 months is going to be acquisition, versus new de novos and branching.

Brian Martin - Howe Barnes Hoefer & Arnett

Okay, all right. And any particular markets stronger than another, right now, that you're looking at?

Lynn Fuller

We're seeing opportunities in most all of our markets. But I would say that we have a preference for the Minneapolis area. We have a preference for the markets out west, probably not as much of a preference in those markets, where we already control over a third of the market. Dubuque would be an example of that. Galena would be an example of that, where we already have a very, very high percentage of market share.

Brian Martin - Howe Barnes Hoefer & Arnett

Okay, all right. And just lastly, you guys talked about the loan pipelines expanding a little bit. Is that, I guess, what appears to be driving the loan demand? Is it the Western market, is it still the Midwest, or kind of just a collection of all the banks?

John Schmidt

I'd say, it's a collection. We're not seeing anything unusual. It's just good summer activity. A couple of transactions in the $8 million to $10 million range, which will certainly help add those numbers up quicker.

Lynn Fuller

Maybe, it's the easiest to address the slower markets. I would say the Phoenix area is still…

John Schmidt

Phoenix.

Brian Martin - Howe Barnes Hoefer & Arnett

Okay, that's all I had guys. Thanks.

John Schmidt

Thanks, Brian.

Operator

Thank you. (Operator Instructions). And Mr. Fuller, it looks like there are no further questions. I'll turn it back to you for closing comments.

Lynn Fuller

Very good. Thank you. In closing, as you've heard, Heartland's core financial performance remains very solid. However, like our peers, regional problems in real estate have resulted in increased levels of nonperforming loans, provision expense, and charge-offs that Ken Erickson referred to. We have allocated additional resources and focused our energies in those markets that are most challenged. We believe that we're properly reserved, and we are hopeful that an improving trend will be evident by year end.

Contrary to our peers, we have been able to hold our net interest margin steady at just under 4% for the last four quarters, and continue to show increases in earnings per share from continuing operations. We're well capitalized and poised to take advantage of acquisition opportunities that surface in our current markets. And again in closing, I'd like to thank all of you for joining us today. We certainly hope that you'll be able to join us again in our next quarterly conference call and that's scheduled for October 27th of this year. So, have a good evening everyone.

Operator

Thank you. Ladies and gentlemen, that will conclude today's teleconference. We do thank you again for your participation. And at this time you may disconnect.

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