Heartland Financial USA Inc (NASDAQ:HTLF) Q1 2016 Earnings Conference Call April 25, 2016 5:00 PM ET
Lynn Fuller - Chairman and Chief Executive Officer
Bruce Lee - President
Bryan McKeag - Executive Vice President and Chief Financial Officer
Andrew Townsend - Executive Vice President and Chief Credit Officer
Matthew Clark - Piper Jaffray
Andrew Liesch - Sandler O’Neill
Greetings and welcome to the Heartland Financial USA, Inc. First Quarter 2016 Conference Call. This afternoon, Heartland distributed its first quarter press release and hopefully you have had a chance to review the results. If there is anyone on this call who did not receive a copy, you may access it at Heartland’s website at www.htlf.com.
With us today from management are Lynn Fuller, Chairman and Chief Executive Officer; Bruce Lee, President; Bryan McKeag, Executive Vice President and Chief Financial Officer; and Andrew Townsend, Executive Vice President and Chief Credit Officer. Management will provide a brief summary of the quarter and then we will open up the call to your questions.
Before we begin the presentation, I would like to remind everyone that some of the information 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 concerning the company’s hopes, beliefs, expectations and 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 maybe obtained on the company’s website or the SEC’s website. [Operator Instructions] As a reminder, this conference is being recorded.
At this time, I will now turn the call over to Mr. Lynn Fuller at Heartland. Please go ahead, sir.
Thank you, Matt and good afternoon everyone. We appreciate everyone joining us today as we discuss Heartland’s performance for the first quarter of 2016. For the next few minutes, I will touch on the highlights for the quarter and then I will turn the call over to Heartland’s President, Bruce Lee, who will cover progress on our key operating strategies. And then, Bryan McKeag, our EVP and CFO, will provide additional color on Heartland’s quarterly results, followed by Drew Townsend, our EVP and Chief Credit Officer, who will offer insights on credit-related topics.
Well, this year, we highlight Heartland’s overarching objective of balancing profit and growth, with a continued goal of doubling both every 5 to 7 years. I am very pleased to report that our company is performing extremely well on both fronts and we are definitely off to a great start in 2016, reporting the best earnings quarter in our 35-year history.
In today’s release, we reported net income of $20 million, a 27% increase over the same quarter last year and a 37% increase over last quarter. On a per share basis, Heartland earned $0.83 per diluted common share for the first quarter. That’s an 8% improvement over the same quarter last year and a 22% improvement over last quarter. Annualized return on average common equity for the quarter reached 12.68% and return on average tangible common equity was 16.45%. Our tangible common equity ratio of 6.32% for the quarter reflects the goodwill created through our acquisitions and remains within our target range of 6% to 7%. Book value and tangible book value per common share continued to increase ending the quarter at $27.15 and $20.86 respectively. With Heartland’s stock price at just over $31 per share, we are trading at a 15% premium to book value and less than 10x forward earnings, which is substantially below our analyst price indications of $36 to $44 per share.
Well, we are also very pleased with our net interest margin, which reached 4.19% for the quarter. Our success in maintaining margin above many of our peers is a result of continuous pricing discipline on both sides of the balance sheet. Net interest income in dollars has also increased steadily through each of the last 14 quarters.
Now, moving on to the balance sheet, assets reached a new record high of $8.25 billion at quarter end. Loan growth for the quarter was $500 million, a 10% increase. Year-over-year, loans increased $1.26 billion and that’s a 30% increase. Deposit growth for the quarter was $518 million, an 8% increase and year-over-year deposits increased $1.66 billion, a 31% increase. In a few minutes, Bruce Lee will address loans and deposits in more detail.
I am also pleased to provide an update on our progress towards lowering Heartland’s efficiency ratio, which reached 66.9% for the quarter and remains on track to reach 65% by year end 2016. Following Bruce Lee’s comments, Bryan McKeag will address non-interest expense in more detail.
Well, another quarterly highlight of note is Heartland’s exit from the Small Business Lending Fund, or SBLF, with the redemption of $82 million in preferred stock originally issued to the U.S. Treasury in September of 2011. We are grateful to have been a part of the SBLF during which time we enjoyed the low cost of capital while playing an important role in bolstering the economy during the very difficult economic period.
Now for a brief update on M&A activities. In February, Heartland completed its acquisition of CIC Bancshares, Inc./Centennial Bank in Denver, Colorado. Centennial Bank was merged into our Summit Bank & Trust subsidiary and renamed Centennial Bank and Trust. We now have nearly $1 billion in assets in 17 banking centers serving Denver and surrounding mountain communities. The system conversion for Centennial is planned for late this quarter. Additionally, in March, Heartland completed a successful system conversion for Premier Valley Bank in Fresno, California. With respect to M&A, we remain actively committed to pursuing only those deals that will be accretive to our current shareholders’ earnings per share and produce a minimum income rate of return of 15%.
Well, with respect to our dividend, I am pleased to report that at its April meeting, the Heartland Board of Directors elected to maintain our dividend at $0.10 per common share payable on June 3, 2016. In concluding my comments today, I would also like to share with you that earlier this month SNL Financial published its list of the best performing regional banks for 2015. And of the 102 eligible regional banking companies, Heartland was ranked #18.
I will now turn the call over to Bruce Lee, Heartland’s President, who will provide an overview of the company’s strategic initiatives. Bruce?
Thank you, Lynn. The focus of my comments today is on the Heartland subsidiary banks and how collectively our banks are working to execute on our top priorities for 2016. Among these priorities is the achievement of profitable, sustainable organic growth. Fortunately, we are still early in the year as the loan portfolios contracted during the quarter at several of the banks. Net of the CIC Bancshares acquisition, total loans decreased $79 million or 1.6%, with the month of March reversing the trend and pointing to a stronger second quarter. Pipelines are strengthening as seasonal activity resumes. As we analyze the economic conditions in our larger markets, we are optimistic. We believe our geographic diversity continues to reduce risk as 10 of the 15 MSAs served by Heartland banks show stable to improving economies.
Looking at deposits, our emphasis continues on non-time, which remained flat for the quarter. We view this as a reflection of seasonal fluctuations that net of acquisitions has occurred the first quarter in each of the previous 3 years. Deposit composition continues to reflect a favorable mix, with non-interest demand deposits at 30%, savings and money markets at 53% and time deposits at 17% of total deposits.
Moving briefly to non-interest income, we are seeing solid progress from several fee-producing business lines as we expand our footprint. Specifically, for linked quarters, treasury management and private client services, including wealth advisory and retirement plan services, both increased in excess of 10% and residential mortgage origination and servicing revenues increased over 40%.
Focusing a bit deeper on our residential mortgage unit, we have commented in recent quarters on efforts to improve the profitability of this business line by consolidating loan origination offices within our banking footprint. We have closed most out-of-footprint locations, channeled resources toward our most promising in-footprint opportunities and as a result, are realizing significant cost savings. Originations were $238 million, with a purchase to refi ratio of 60-40 and a continuing trend towards more purchase business.
With interest rates remaining at attractive levels for homebuyers, we are well positioned going into the second and third quarters, the peak season for new loan originations. Heartland’s mortgage servicing portfolio expanded to $4.1 billion during the quarter, an increase of over $500 million during the last year. We show $30.5 million of MSRs on our books, which is valued at approximately $8 million more than book value. Finally, I am also pleased to note that all 10 Heartland subsidiary banks are profitable in the first quarter and are committed to maintain that status going forward.
I will now turn the call over to Bryan McKeag for more detail on our quarterly financial results.
Thanks Bruce and good afternoon. I will take the next couple of minutes to discuss the main drivers of our results and provide updates on key operating metrics for the quarter. I will start with the investment portfolio, where investments available for sale increased $112 million, while investments held to maturity declined $8 million. The total investment portfolio ended the quarter at just under $2 billion, representing 24% of assets, which is unchanged from last quarter. Tax equivalent yield on the portfolio increased 11 basis points for the quarter to 2.95%. The duration of the whole portfolio was 4.1 years and 3.8 years for just the available for sale portfolio, which is up slightly from the prior quarter.
Moving to goodwill and other intangibles, where goodwill of $127.7 million at quarter end increased $29.8 million during the quarter as a result of our Centennial Bank acquisition. Other intangibles of $61.4 million at quarter end increased $4.5 million during the quarter. This line item includes $26.5 million of core deposit intangibles, which increased $4.9 million this quarter as a result of our Centennial Bank acquisition and mortgage servicing rights, which ended the quarter at $30.5 million, relatively unchanged from the prior quarter as the MSRs booked on loans sold during the quarter were offset by amortization of existing MSRs. As Bruce mentioned, the estimated value of the MSR is approximately $8 million higher than our recorded book value.
In regards to our regulatory capital ratios, while we have not finalized our regulatory reports, when we do file those reports next quarter, we expect to report a total risk based capital ratio of about 12%, down from 13.74% last quarter, Tier 1 capital ratio of about 10%, down from 11.56%, common equity Tier 1 ratio at about 8.15%, down slightly from 8.23% and the Tier 1 leverage ratio at about 8.2%, down from 9.58% last quarter. Even though these ratios declined as we expected due to our redemption of the SBLF preferred stock and our Centennial Bank acquisition during the first quarter, they all still comfortably exceed well capitalized levels. In addition, as Lynn mentioned before, our tangible common equity ratio rose 22 basis points this quarter to 6.32%.
Shifting to the income statement, where net interest income continued to grow, reaching a new high of $72.7 million this quarter, up $10 million or 16% from the prior quarter as a result of significant quarter-over-quarter lift from our two most recent acquisitions. The net interest margin remained strong, climbing 20 basis points this quarter to 4.19% as yields on both loans and investments increased by 21 basis points and 11 basis points, respectively. And interest costs on deposits and borrowings declined 1 basis point compared to last quarter. This quarter, the net interest margin includes a positive effect of 21 basis points from the amortization of purchase accounting discounts, which is an increase of 9 basis points over the prior quarter. In addition, the 0.25% increase by the Fed last December had a positive impact on both loan and investment yields and a minimal effect on deposit and borrowing costs. We estimate that the rate increase had a 4 to 5 basis point lift on the net interest margin this quarter.
Non-interest income totaled $29.6 million for the quarter, up $5.2 million from last quarter, as service charges and fees increased $500,000 as a result of the increase in non-time deposit balances and increased treasury management related fees. In addition, gain on the sale of loans for the quarter was $11.1 million, up $4 million or 56% from the prior quarter, primarily due to higher mortgage loan application activity, which was up 33% quarter-over-quarter.
Switching to non-interest expense, total expenses were $70.3 million, an increase of $4.4 million from the prior quarter. Expenses this quarter included approximately $1 million in non-recurring costs related to our completed acquisitions, which is a similar amount to last quarter. The expense category of note – expense categories of note include salaries and benefit expense, which increased $8.1 million from the prior quarter. There were several changes in this area including increases in the costs from our two most recent acquisitions, higher incentive, insurance and retirement plan costs due to quarter-over-quarter accrual changes, losses on the sale of valuation or valuation of assets decreased $3.9 million this quarter, primarily due to last quarter’s $3.2 million write-down on an OREO property and finally, other non-interest expense was down $1.6 million from last quarter, as last quarter included $1.4 million of costs for historical tax credits, while none were recorded this quarter.
For the quarter, our efficiency ratio improved to 66.9% from 68.53% last quarter, as core expenses increased $9 million while core operating revenue increased $15 million compared to the prior quarter. The improvement is primarily the results of the benefits of scale and cost savings from our acquisitions and other internal initiatives as well as a stronger quarter for our mortgage business. Over the long haul, we are confident that our efficiency ratio will continue to trend towards our goal of 65% by year end. The effective tax rate was just over 33% for the quarter, which as I mentioned included no historic tax credits.
To wrap up, I would add the following relative to our results going forward. First, loan growth, although we have experienced decline in the past two quarters on an organic basis, we continue to expect 1% to 2% growth on average per quarter, but our growth will likely be lumpy from quarter-to-quarter. The net interest margin is expected to remain strong, but is likely to pull back a bit into the 4.10% to 4.15% range. Mortgage production is expected to follow normal seasonal trends, coming off a solid first quarter. Other fee income areas are expected to show moderate increases over first quarter results, as we work to increase our penetration of these services into our existing customer base, but more importantly, our newly acquired customer bases and markets. And finally, core expenses are expected to remain flat – relatively flat with the exception of mortgage commissions, which should follow mortgage production trends.
And with that, I will turn the call over to Drew Townsend, our Executive Vice President and Chief Credit Officer.
Thank you, Bryan. I will begin my remarks by discussing the changes in Heartland’s non-performing loans and other real estate owned. This quarter resulted in non-performing loans increasing from 0.79% to 0.88% of total loans. Out of the total increase of $13.8 million in new non-performing loans, $12.9 million were from the member banks and $900,000 were from Citizens Finance, Heartland’s consumer finance company. Within the bank total, $1.6 million was purchased during the first quarter with the Centennial Bank acquisition. At the bank level, $8 million or 62% was attributed to a new commercial – to new commercial and ag non-accrual loans and $4.9 million or 38% occurred in the retail portfolios. The increase in the non-performing loans in the commercial sector was concentrated primarily in three banks, Wisconsin Bank & Trust, Premier Valley Bank and Centennial Bank and Trust. The majority of these new non-accrual commercial loans were from the bank portfolios, which have been acquired since the beginning of 2015. There are 8 non-performing loans with individual loan balances exceeding $1 million. In aggregate, these 8 loans totaled $15.5 million or 32% of our total non-performers. 6 of these loans totaling $11.6 million came with the acquisitions closed in 2015 and in year-to-date 2016. In the retail portfolios, $3.4 million or 76% of the new non-performing loans resulted from an increase in repurchases of residential real estate loans from our service loans portfolio. Of the $3.4 million, $3.2 million of these loans are FHA or VA-guaranteed, so our loss exposure is considered minimal.
In summary, the increasing trend of non-performing loans is largely due to recent acquisitions and does not appear to be concentrated in any one particular industry or geographic location or region. It should be noted that Heartland’s Special Assets team is actively engaged with these borrowers to obtain appropriate and timely resolution. The 30 to 89 days delinquency ratio increased from 0.31% to 0.45% in the first quarter. One large sub-rated agricultural relationship represents nearly 50% of this delinquency total. Other real estate owned remained flat in the first quarter at $11.3 million. Non-performing assets in total as a percent of total assets increased from 0.67% to 0.73%, almost exclusively in the loan portfolios as previously discussed.
Sales of other real estate owned resulted in a reduction of $2.1 million in the first quarter. In this quarter, we took write-downs in the amount of $411,000 on other real estate owned. Our existing portfolio of other real estate is made up of 11 residential properties aggregating to $1.5 million and 38 commercial properties that aggregate to $9.8 million. Provision expense was $2.1 million in the first quarter, flat if compared to the fourth quarter. $1.2 billion of loans from our acquisitions still reside in the purchased accounting pool and are covered by the valuation PCI reserves. As credit decisions are made on these accounts in future quarters, a provision expense will be necessary to establish the associated allowance for those loans. Net charge-offs in total approximated $1 million in the first quarter. Net charge-offs at the banks for the quarter totaled $204,000, with the balance taken by our consumer finance company.
As shown in the earnings release, our coverage ratio of allowance for loan and lease losses as a percent of non-performing loans and leases was 102.79%, down slightly from 122.77% at year end 2015. This noted decrease is largely a result of the increase in the non-performing loans. The allowance for loan and lease losses as a percent of loans and leases decreased from 0.97% to 0.90% this quarter. Valuation reserves totaling $35.9 million are recorded for those loans and payment acquisitions. Excluding those loans covered by the valuation reserves would result in an allowance-to-loans ratio to 1.17%, which would compared to 1.15% at year end.
As a follow-up to comments made last quarter with respect to Heartland’s exposure to the ag sector, I am pleased to report that to-date the Heartland banks servicing our ag portfolios have seen a very limited number of downgrades to borrowers in this segment. In addition, no credit losses have identified with those ag loans. It’s also important to note that with the Premier Valley acquisition, Heartland did not acquire any agricultural credit exposure in the presently stressed California market. Lastly, it’s noted with the recently completed acquisition of Centennial Bank, Heartland’s direct exposure to the oil and gas industry remains below $10 million.
That concludes my remarks. I will now turn the call back over to Lynn.
Thank you, Drew. Now, we will open the phone lines for your questions.
Thank you. [Operator Instructions] Our first question comes from Matthew Clark from Piper Jaffray. Please go ahead.
Yes, good afternoon guys.
Maybe just first on the loan yields in the quarter, it sounds like the Fed increase helped a little bit, 4, 5 basis points. Just curious going out there are also some prepayment fees in there this quarter and just what – I am just curious if they were last quarter, too?
Yes, I think we do in the back show what our fees are quarter-over-quarter. I think they were fairly flat, just up a little bit, maybe $100,000 from last quarter. I think the loan yields are affected by that Fed increase. They are also affected by the purchase accounting amortization, which the bulk of it – almost all of it, in fact, throws close to all those loan accounts. And one thing we did notice is that it looked like the portfolio yield rates on Centennial and Premier Valley were slightly higher than Heartland’s overall portfolio coming in, so that probably had a little bit of lift as well.
Okay. And then just any update on loan pricing, I think my – what rates were on new loans this quarter relative to last?
Hi, Matt. This is Bruce. On the commercial side, it’s a very, very competitive market out there as everyone is going after the best quality loans, but we still feel that while we have to compete at that space, we will be able to hold our yields fairly well during the next couple of quarters.
Okay. And just on the mortgage business and the profitability kind of improvement going on there obviously gain on sale helping this quarter, but just curious what the profitability for that business line was at the end of the quarter and kind of what additional savings might there be going forward or not?
Yes, I don’t have that number with me. We don’t have the line of business numbers. I just don’t have them with me at the moment. I think we did have a profitable quarter, but I don’t have that number.
Where our focus is in that business is all around margin right now. Our margin was a little weaker than we had hoped in the first quarter and we have already made improvements there. We think that there is a little more room still to go. And we feel very comfortable that we will have ongoing profitability in the second and third quarters as our expenses also come in line as we consolidate and move offices back into our traditional bank footprint rather than freestanding LPOs.
Got it. Thanks, guys.
[Operator Instructions] And our next question comes from Andrew Liesch from Sandler O’Neill. Please go ahead.
Just following up on the mortgage question, relative to other banks that I have seen report so far, you guys have done much better on the gain on sale there. So, I am just curious is this $11 million number repeatable do you think in this quarter?
If the volume continues to be in the purchase space, especially not just in the refi, we feel very comfortable that the – that is repeatable. Again, our mix really helps us there on the purchase side.
Got it. And then, on the expenses you said remained relatively flat on a core basis. So I mean, if we back out the merger cost and maybe the OREO, maybe like $68.5 million, is that what you meant by that, Bryan?
Yes. But I think you also have to add in another month of Centennial Bank, which is probably that, plus we do have merit increases, which take effect for us, effective in April, so all of that above wipes out the two negatives that you had. So it comes back to about the same spot.
Wonderful, very good. Thanks so much.
[Operator Instructions] And if there are no further questions, I would like to turn the floor back over to Mr. Fuller for any closing remarks.
Thanks Matt. Well, in closing, I am very pleased to begin 2016 with a record setting first quarter. I think this excellent quarter is confirmation of our commitment to execute on Heartland’s master strategy of balanced profit and growth as we continue to pursue our historic goal of doubling earnings and assets every 5 years to 7 years. And to maintain and enhance our current course, our management and Board have outlined the following key priorities for the year ahead. Number one, acquire, develop and retain the talent needed to grow to $10 billion and beyond. Number two, maintain high credit quality and enhance the credit delivery system for an asset size of $10 billion. Number three, achieve profitable, sustainable organic growth. And number four, achieve and digest profitable acquired growth. Number five, acquire and implement the integrated technology needed to improve operating efficiencies, enhance product and service offerings and customize delivery of service to customers. And last, number six, provide a higher level of customer satisfaction for both internal and external customers.
I would like to thank everyone for joining us today. Our next quarterly conference call is scheduled for July 25, 2016. However, next month is Heartland’s Annual Meeting of Shareholders on Thursday, May 19, at 6 p.m. Central Time, at the Grand River Center in Dubuque. I hope you can all join us, as we are looking forward to seeing you there. Have a good evening everyone.
Thank you. This concludes today’s conference. Thank you for your participation. You may your lines at time.
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