Heritage Financial Corporation (NASDAQ:HFWA) Q3 2019 Earnings Conference Call October 24, 2019 2:00 PM ET
Jeff Deuel - CEO
Don Hinson - EVP & CFO
Bryan McDonald - COO
Conference Call Participants
Jeff Rulis - D.A. Davidson
Gordon McGuire - Stephens
Matthew Clark - Piper Jaffray
Jackie Bowen - KBW
Tim O'Brien - Sandler O'Neill
Ladies and gentlemen, thank you for standing by, and welcome to the Heritage Financial third quarter earnings call. (Operator Instructions) As a reminder, the conference is being recorded.
And I would now like to turn the conference over to our host, President and CEO, Mr. Jeff Deuel. Please go ahead.
Thank you, Lori. Welcome to all who called in and those who may listen later, this is Jeff Deuel, CEO of Heritage. Attending with me are Don Hinson, our CFO; and Bryan McDonald, our Chief Operating Officer.
Our earnings press release went out this morning premarket, and hopefully, you have had an opportunity to review it prior to the call. Please refer to the forward-looking statements in the press release.
We're pleased with our progress as we continue to build our franchise and generate attractive financial results for our shareholders. As you know, we've made significant investments in Seattle, Bellevue and Portland and we're seeing the benefits of the two acquisitions we completed in 2018 as well as the teams we've added in those markets.
Together, the Seattle, Bellevue and Portland markets represent significant opportunities for Heritage and we believe we have positioned ourselves well to continue to execute in those markets. We also see good performance in our traditional markets along the I-5 Corridor. Despite significant loan production, our net loan growth continued to be a challenge due to the elevated loan payoffs.
On the bright side, the loan portfolio pipeline has grown nicely and we have strong originations -- had strong originations during the quarter. We believe we have laid down a good foundation, which we will -- which will continue to produce attractive results for our company in the future.
While we have continued to see competition for deposits in the third quarter, our loan-to-deposit ratio of 82% has enabled us to carefully manage pricing competition and maximize our NIM. We continue to focus on protecting our core deposit franchise, which we view as one of our key strengths.
Don Hinson will now take a few minutes to cover our financial statement results including color on our core operating metrics.
Thank you, Jeff. I'm going to start with a quick overview of earnings before heading into more detail on our balance sheet, credit quality, income statement and capital management.
Our diluted earnings per share for Q3 was $0.48, which is up from $0.43 in Q2. The increase in earnings from Q2 was due mostly to a combination of an increase in noninterest income and decreases in noninterest expense and the provision for loan losses.
Moving on to the balance sheet. Total asset growth was strong in Q3 due to a $215 million increase in total deposits. This increase in deposits is net of $20 million of brokered CDs that matured and were not renewed in Q3. Approximately 50% of the deposit growth in the quarter was due to a $109 million increase in noninterest-bearing demand deposits.
Q3 is usually our strongest deposit growth quarter of the year. The main drivers of the growth this past quarter appeared to be a combination of seasonal buildup of deposit accounts, new commercial deposit relationships and some customer-specific events such as the sales of businesses where the funds were kept with the bank at least in the short run.
Gross loans grew approximately $13 million in Q3 and have increased about $77 million year-to-date. The annualized year-to-date growth rate is 2.8%. Bryan McDonald will further discuss loan production in a few minutes.
Regarding credit quality, we experienced a significant increase in nonaccrual loans in Q3 due mostly to one $20 million ag relationship whose primary business is tree fruit. We put the credit on nonaccrual status in Q3 due to our concern over the borrower being able to meet its budget in order to pay off this year's crop line in addition to a carryover from the 2018 crop line.
The collateral coverage is currently adequate to satisfy the credit exposure with a loan-to-value of approximately 75%. About 35% of this collateral is expected proceeds from the partially harvested 2019 crop. We are monitoring this credit carefully and we'll be obtaining updated collateral valuations in Q4.
Although we had large increase in nonaccrual loans, the combined total of nonaccrual loans performing TDRs and potential problems loans decreased by $13 million from Q2 levels. In addition, net charge-offs decreased 3 basis points in Q3 and are 5 basis points year-to-date, which is a decrease from 6 basis points through Q3 of last year.
Although we aren't happy about the increase in nonaccrual loans, we don't believe this is indicative of widespread problems in our loan portfolio. The net interest margin decreased 12 basis points in Q3 due mostly to a similar 12 basis point decrease in the loan portfolio yield. Although a portion of the decrease in the loan portfolio yield was due to the rate environment, 9 of the 12 basis point decrease was related to a combined impact of the large ag credit that was put on nonaccrual status and lower discount accretion.
The cost of total deposits leveled off in Q3 increasing only 1 basis point from Q2 levels. The strong growth in noninterest-bearing demand deposits helped limit our cost of total deposits at 38 basis points in Q3. Due to the shape of the yield curve, forecasted 2019 rates and competitive pricing pressures, we do expect continuing pressure on our net interest margin in the near term.
Noninterest expense decreased $828,000 from the prior quarter. The improvement was driven mostly by lower compensation expense, FDIC premiums and OREO expenses partially offset by higher business and use taxes. As mentioned in the earnings release, we were able to use a credit for FDIC premiums in Q3 and we still have 883,000 in credits, which will be used in future quarters if the deposit insurance fund remains at a certain level.
As also mentioned in the release, we incurred an assessment of $537,000 from the Washington State Department of Revenue that was the result of an audit of a prior 4-year time period. We expect this line item to decrease to normalized levels in Q4.
As a result of our overall lower cost and higher asset levels, we saw a nice improvement in our overhead ratio, which moved down to 2.69% in Q3 from 2.81% in Q2.
And finally, moving on to capital management. Due to our strong capital levels, we took advantage of lower share prices in Q3 to repurchase 265,000 shares at a weighted average price of $26.23. As of the end of Q3, we still have 640,000 shares available for repurchase under our current stock repurchase plan. Even with these buybacks and our strong asset growth in Q3, our tangible common equity ratio only decreased to 10.4% from 10.5% at the prior quarter end.
As a result of our strong capital position and earnings performance in addition to a record dividend of $0.19 this quarter, the Board has approved a special dividend of $0.10 for Q4. This is the ninth consecutive year we have paid a special dividend in addition to our regular quarterly dividends. We will continue to monitor quarterly dividend levels and potential share repurchases but also like having the flexibility if and when a potential acquisition opportunity arises.
Bryan McDonald will now have an update on loan production.
Thanks, Don. I'm going to provide detail on our third quarter production results by area starting with our commercial lending group. In the third quarter, our commercial teams closed $305 million in new loan commitments, very similar to the volume closed in the second quarter of 2019, and up 63% from the $187 million closed in the third quarter of 2018. New production during the third quarter was centered in Seattle and Bellevue at $98 million, Tacoma at $55 million and greater Portland at $42 million.
Commercial team loan pipelines ended the second quarter at $440 million, down 8% versus the second quarter, but remained up 29% compared to the beginning of the year. Largest pipeline concentrations were in our Seattle, Bellevue teams, which saw their pipeline increase 9% to $162 million from last quarter, our greater Portland teams, which ended the quarter with a pipeline of $86 million and our greater Tacoma teams, which ended the quarter with a pipeline of $68 million.
Gross loans increased only $13 million during the third quarter on a 1.4% annualized rate due to continued higher levels of prepayment and payoff activity. Loan prepayments and payoffs during the quarter totaled $169 million versus $160 million in the second quarter of 2019 and the elevated $153 million average we experienced in the last three quarters of 2018.
Payoff and prepayment activity in the third quarter was caused by a higher level of business in real estate sales, customers using cash to pay off debt and clients paying off loans through our active portfolio management efforts.
SBA 7(a) production in the third quarter included 15 loans for $4.9 million and the pipeline ended the quarter at $14.8 million. This compares to last quarter where we closed 9 loans for $9 million and the pipeline ended the quarter at $13.2 million. SBA September 30, 2019, fiscal year-end Seattle and Portland district lender rankings for both 7(a) and 504 loans were just released. For the 7(a) program, we ended up with 50 loans for $42 million, which is 150% increase over 2018.
And in the 504 loan program, Heritage Bank ranked #1 again within the Seattle District office with 16 approvals for $24 million. Consumer production during the third quarter was $59 million, up from $44 million in the second quarter and up from $41 million closed in the first quarter of 2019. The change in volume is due primarily to an increase in indirect lending.
Moving on to interest rates. Our third quarter interest rate for new commercial loans was 50 basis points lower, decreasing to 4.66% from 5.16% last quarter. In addition, the average third quarter rate for all new loans was 4.87%, dropping from 5.26% last quarter.
The mortgage department closed $47.9 million of new loans in the third quarter compared to $30.6 million closed in the second quarter and $44 million in the third quarter of 2018. The mortgage pipeline ended the quarter at $39 million, same as the second quarter of 2019 and down moderately from $41 million in the third quarter of 2018. Just as a reminder, we reduced the size of our mortgage platform during the second quarter and we only sell a portion of our mortgage loans to the secondary market.
I'll now turn the call back to Jeff.
Thank you, Brian. I'd like to cover a few observations. Here in the Pacific Northwest, we continue to enjoy the economic vitality along the I-5 Corridor. Validations continue to be stable for commercial real estate and single family. However, competition for loans and deposits continues to be heavy.
In spite of the positive economic environment in the region, we remain cautious about our concentration levels and are operating at levels that provide us flexibility to take advantage of high-quality loan opportunities while still being able to maintain discipline focusing on loan quality and yield.
We have strong teams in the metro markets, markets which are relatively new to us and we will continue to execute in those markets to generate future growth. We continue to benefit from our balance sheet liquidity and the high-quality granularity of our deposit base.
While the cost of deposits has been trending up, the overall costs are still relatively low. We continue to manage our capital position to support our planned organic growth as well as positioning the bank so we can respond to future M&A opportunities when they present themselves.
Before we go to questions, I would just like to add a few things about the large nonaccrual ag loan Don covered in his comments. Clearly, we are not pleased to be taking this action but there is some history here. Our ag portfolio has been around since 1999 when we acquired Central Valley Bank, which is located in the central part of the state in the Yakima region.
For the past couple of years, we have anticipated potential weakness in this sector and we have been actively managing our ag portfolio. As a result, you have been seeing this credit and others working their way through our credit management process. We have been taking action on this loan and certain other loans over the past several quarters, which is evidenced in our prior quarterly updates and comments.
Please also keep in mind that our entire ag portfolio is less than 3% of our entire loan portfolio. We have banked this particular ag customer for many years and we believe it is prudent at this time to put it on nonaccrual status even though we believe the loan is fully collateralized and at this time, we do not anticipate a significant loss. While this addition to the nonaccrual category is notable, we believe we are monitoring it appropriately.
On another note, during the Q2, we added seven loans totaling $27 million to the potential problem loan category, again a result of our active portfolio management process. It should be noted that 2 of those loans have subsequently paid off, 2 have paid down significantly and the remaining loans are showing positive progress.
Lastly, I would point out to you as you watch us actively manage the loan portfolio that you will typically see loans either move up or out but over time, our actual credit costs have been pretty low. In spite of these recent credit highlights, we believe we are well positioned for the future with lots of opportunities in our newer metro markets as well as in our traditional markets along the I-5 Corridor in Washington and Oregon.
That is the conclusion of our prepared comments. So Lori, we're ready to open up the call now and we welcome any questions.
(Operator Instructions) Our first question is from the line of Jeffrey Rulis with D.A. Davidson.
Jeff, just a follow-up on the ag credit. I know that the visibility may not be there. But just kind of a workout time line. I mean you said it's a long-time watched credit and you know the customer well, but I guess is this just a workable situation? And at what point does this get? I know that it's too early to tell.
Well, we're taking the action that we think is appropriate based on what we know today, Jeff. And -- we have walked through with our credit admin team the variety of scenarios that could play out. Sometimes these things correct themselves in a pretty short period of time, meaning months as opposed to years, but in this case, there is the potential that this could be a longer-term workout.
We just don't know at this point. I think the complication here with the ag credits is the cycle times are pretty long and one of the things that were -- that's causing us to take the position we are is there is full collateral coverage as we've outlined, but a portion of that collateral is tied to the current crop, which is in the process of being harvested.
And we're watching it weekly to make sure that it's progressing in a way that it should. But the cycle would cause us to have the crop be harvested, then it has to be tested for quality and pricing and it has to be packaged and it will be sold over a period of months. And we're talking about a pretty significant amount of production. So that alone could take this -- in all likelihood, this will at least go into mid- to late 2020 before I think it gets resolved.
And anything else in the remaining bucket that's either kind of chunkier in that NPA balance? Anything else?
No. This, by far, is the biggest one. It's one that we've been watching for a long time, as I said. Just in terms of our ag portfolio itself, we've already regarded almost half of it over the last couple of years. So we're not necessarily seeing any lingering things in that portfolio that would present themselves in the next couple of quarters, at least we don't see it right now.
Jeff, well I've got you. The -- would you hazard a kind of a guess on net loan growth for 2020? You've had data on activity and I know that you don't have a crystal ball, but given the cautiousness out there, and other I mean anything that -- or just general thoughts on growth for the year? It doesn't have to be a number.
Well, you could imagine how frustrated we are with the circumstances with the payoffs and the paydowns, and it's particularly frustrating not just for us but our production folks. I mean they -- it feels like we're just churning. We're not actually. What we're putting on is new business, new loans, new relationships in a lot of cases.
We always talk in terms of 6% to 8% growth with normalized payoffs. We haven't had normalized payoffs in almost two years. So maybe, we should be tempering that and saying low to middle single digits. The thing that makes that hard question to answer is, we can see through the pipeline what all of these teams are capable of producing if we ever get normalized payoffs. So I think we're going really see the balance sheet take off.
Let me read just one quick last one. Don, you touched on the expenses. There is some puts and takes there, obviously, with the use of some of those credits as well as the -- I guess the audit assessment. The baseline for that and go forward, would you just continue to circle us back to the overhead ratio and attempts there? Or if you could talk about expense run rate, would also be of interest?
Yes. I think the overall -- I mean like I said there was some give and take this last quarter with one benefit and one kind of subtraction on that. Overall, I think it's a probably decent run rate. I will say that we have some technology initiatives going on that will start hitting in Q4, that will -- might bump it up a little bit, but I think overall, it's probably a fairly decent run rate.
We only have CECL that we're implementing that, obviously, will take a little bit of funds, and in addition to some treasury management system that we're implementing. So that could bump it up closer to the $37 million mark. As I've mentioned before, but I think it will still be kind of between where we're in Q3 and that $37 million mark is probably good run rate.
And we'll go next to Gordon McGuire with Stephens.
Don, I just wanted to circle back on your comment about the NIM, continuing pressure on the NIM. With the interest recovery this quarter impacting about 4 basis points, I would have guessed I would kind of snapback next quarter and be more flattish. Can you just kind of walk me through the NIM?
Gordon, I continue -- I expect the NIM to continue to have pressure, downward pressure, in Q4. We had a rate cut in September that wasn't fully realized for the quarter and we'll probably have another one in the next week. I think the combination of those things and then put the new loans are going on with as compared to the current portfolio and really the -- although this portfolio is smaller, we have the same thing going on there.
I do expect some contraction again, it's -- the go forward where on the loan yields the new nonaccrual is five basis points for the quarter, it's still going to be an impact probably of three basis points in Q4. So again there is a small snapback there, but I would still expect the margin to increase 5 to 10 basis points in Q4.
5 to 10 from here?
Okay. And then just on the CD costs. I think I missed your commentary about the brokered deposits. How much of the CD cost increase was related to those this quarter?
The brokered CDs would actually cause the CD rates come down because they were higher.
They were higher and we did not renew the brokered CDs. We took out earlier like I think in Q1.
Okay. So the increase was all -- pretty much all from the more core book?
Yes. We had in -- I would say in Q2 and parts of Q3, we actually slowed it down in Q3. About mid-Q3, we actually lowered our CD rates, but there is always the lag effect when you put on things like CDs. So in Q2, we have higher rates be competitive because of some competitive rates that were out there in our market, and so we had CD rates up above 2%.
We have actually lowered those down below 2% now. So I would expect that the CD rates will come -- I think will possibly still come up a little bit in Q4 based off again some of the difference between what's going on and what's coming off the portfolio, but the difference will be much less than what was in Q3.
And can you talk about the decision to resume SBA sales? And just whether you would anticipate staying in these levels on a quarterly basis or maybe even getting back to levels a few years back?
Gordon, this is Bryan. So we have a formula and measure against and for the last few we've measured, haven't hit our threshold and so we've retained them, so we'll just continue to look at that. It's certainly the -- what type of gain on sale can we get versus the future interest income and then, of course, the primary changes have an impact on that.
So just generically with prime having moved up, we have [sold less we do.] It is likely as prime continues to go down, the probability of sale will go up but we do measure those one at a time and we also do some fixed-rate SBAs as well. And so those obviously aren't impacted by the declining rate environment.
Our next question from Matthew Clark from Piper Jaffray.
I didn't see in the release and then didn't catch it on the call, but did you quantify the amount of payoffs and paydowns in the quarter?
Matt, this is Bryan. On the commercial side, the payoffs and paydowns were $169 million for the quarter versus $160 million last quarter.
Great. Okay. And then just on the deposit costs. You -- yes, I heard your commentary on CDs and a little bit of a lag effect, but do you feel like we peaked here in terms of interest-bearing deposit costs or do you feel like you've got one more quarter to go before they might start turning lower?
I think overall, we've probably peaked. There's a chance that it could bump up another basis point but I don't -- I think we'll probably peak where it's at and there is a chance it could come down some since the CD portfolio isn't a huge piece of it. And we are again lowering rates selectively on various deposit accounts due to the rate environment. So I think we'll probably peak where we're at.
Okay. And then just any updated commentary on the M&A landscape in terms of discussions you might be having whether or not those have picked up or not?
For first -- Matt, this is Jeff. For first part of the year, things were pretty quiet on the M&A front. We have started having more conversations in the last month or so, but we're not sure what that's going to turn into. It's just where we are at this point.
Our next question from the line of Jackie Bowen with KBW.
I just wanted to touch on the ag portfolio again. Sorry, I know you've discussed it quite a bit. Would you quantify what's taking place with that particular credit as more macro based or more micro based, meaning is it indicative of the environment that borrower is operating within? Or is it something specific to the borrower?
It's both. If you -- if you add up the factors that are impacting this particular customer, it's weather, it's pricing, it's -- a certain portion of it is tied to succession and a certain portion of it is a transition from -- to organic product, which is a pretty big undertaking. So it's a little bit of both.
Okay. That's helpful. And understanding, as we've said ag is less than 3% of the portfolio. Do you -- I guess within the potential problem bucket that you have knowing how much you scrub the portfolio on a regular basis, how much of that is ag?
Jackie, this is Don. On looking on the ag portfolio and it's actually -- it's 10% of the potential problem loans. But if you add up the impact on nonaccruals performing TDRs and within the problems loans combined, it's actually 27% of those amounts combined.
So it's 54% of the nonaccruals and it's 49% of the TDRs, performing TDRs, and it's 10% of the potential problem loans. 39% of the ag portfolio is either classified as either nonaccrual performing TDR's or potential problem loans.
Oh it's 39%, you said?
Okay. And then just one last one from me. In terms of CECL, I know we still have a little bit of time before implementation, but just wondering if you have any updates to provide?
Well, no updates as far as numbers are concerned. We are in process and we are on pace to be able to give a number at the end of January when we release earnings next time. So -- but we're doing things like starting to run the model side-by-side and doing validations from that -- from doing that and making tweaks. So we're on pace and -- but we don't have any numbers to give at this point.
And our next question from Tim O'Brien with Sandler O'Neill.
So, Don, if I heard you right, you said that between the interest reversal on the ag credit and lower discount accretion, that had a 9 basis point impact on the NIM this quarter?
And so both of those items go away but you're still looking for a 5 to 10 basis points of compression beyond that. So maybe just a bit more exacerbated pressure from the rate cuts and it's just a flat curve and those sorts of things. Is that kind of generally how I should look at it?
Yes. Because again it's not the -- the ag nonaccrual loan, it won't -- it will pop back up a little bit but not much from that and I still think that -- again what new loans are going on at compared to what they're coming off at. And again, floating rate loans and investments, again, we don't -- we didn't get a full impact of that in Q3 from the September cut.
And we probably have another cut coming here in October. So I do think it's going to impact it and that will be 50 basis points. That happens within 1.5 months there. But we haven't felt of an impact at all in Q3. So I still think it's going to be 5 to 10 basis points.
And are your thoughts on how the margin situation might play out in the fourth quarter predicated on October cut only? Or does that also take into account a potentially December cut? Obviously, that's going to be -- have a smaller, shorter impact, I guess.
Yes. I am not counting on the December one at this point. But like you said even the December one wouldn't have that much impact on Q4.
And then the ag credit that was downgraded, are they still making payments? Or has that stopped?
They are making payments, but the way the process works those payments are part of the line so it's all one facility but they are -- essentially they are paying, Tim.
And I'll turn it back to our speakers for closing remarks.
Thank you, Lori. If there is no more questions then we're ready to wrap up this quarter's earnings call and we thank you all for your time, your support and your interest in our ongoing performance as an organization. We look forward to seeing several of you over the coming weeks and we thank you for being on the call. Goodbye.
Thank you. Ladies and gentlemen, this conference call will be made available for replay that begins today at 1 p.m. Pacific Time. The replay of the conference runs through November 7 at 11:59 p.m. Pacific Time. You can access the AT&T teleconference replay system by dialing 1 (800) 475-6701 and entering replay access code 472935.
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