First State Bancorp Q3 2007 Earnings Call Transcript

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First State Bancorp (OTC:FSNM) Q3 2007 Earnings Call October 29, 2007 5:00 PM ET


Christopher Spencer - Senior Vice President and ChiefFinancial Officer

H. Patrick Dee - Executive Vice President, Chief OperatingOfficer and Bank President

Pam Smith - Chief Credit Officer

Michael Stanford - President, Chief Executive Officer andBank Board Chairman


Peyton Green - FTN Midwest Securities


Welcome and thank you for standing by. At this time, allparticipants are in a listen-only mode. (Operator Instructions) Today'sconference is being recorded. If you have any objections, you may disconnect atthis time.

Now, I'll turn the meeting over to Mr. Chris Spencer. Sir,you may begin.

Christopher Spencer

Thank you. Welcome, everyone, to First StateBancorporation's Third Quarter 2007 Conference Call.

First State Bancorporation will provide an online simulcastof this conference call on our website, at, and an online replaywill follow immediately and continue for 10 days. There will also be a replayof this call for 10 days after the call toll-free at 866-463-4959.

Your host and conference leaders for this afternoon's callare myself, Christopher C. Spencer, Senior Vice President and Chief FinancialOfficer; H. Patrick Dee, Executive Vice President and Chief Operating Officer;Pam Smith, Chief Credit Officer of First State Bancorporation; as well asMichael R. Stanford, our Chief Executive Officer.

The Board of Directors of First State Bancorporation haveadopted a policy that the company will comply with Securities and ExchangeCommission's Regulation FD in all respects. Consequently, this conference callwill proceed on an agenda, which I will announce momentarily. Matters outsidethis agenda will not be discussed.

The subject matter of this conference call will includeforward-looking statements. These statements are not historical facts, andinvolve risks and uncertainties that could cause First State's result to differmaterially from those contained in such statements.

With that, the agenda this afternoon: Pat Dee will start outwith some high-level comments of the quarter. I will follow that with a reviewof the financial slides that are posted on our website. And we will then openthe call up for analyst questions.

With that, I will turn it over to Pat.

H. Patrick Dee

Thank you, Chris. The third quarter this year washighlighted by a reduction in non-performing assets and potential problemloans. That was brought about primarily through the sale of loans acquired fromFront Range Capital Corporation and the sale of certain OREO properties.

Despite the loan sales, total loans increased during thequarter, and deposit growth was strong. Our net interest margin declinedslightly from the second quarter, but remained fairly strong at 4.57%. With theinterest rate decrease that occurred late in the third quarter, we areprojecting further contraction in our net interest margin in the last quarterof the year, which could be exacerbated by any further rate cuts.

Based on today's rates in OREO and certain growthassumptions, we would expect a margin of between 4.45% and 4.5% in the fourthquarter. Each additional 25-basis-point cut by the Fed is likely to result in afurther contraction in our interest margin in the short run of about 5 to 6basis points.

Early in the third quarter, we completed the conversion ofthe Front Range customers to our system, and recognized the final portion ofour conversion-related expenses. We continue to focus on ways of controllingour expenses, and expect improvement in our efficiency ratio in the fourthquarter.

Expenses in the third quarter were impacted by a net expenseof $449,000 on the redemption of two trust-preferred securities, which willreduce our interest costs going forward.

We're continuing to aggressively market our OREO properties,both the foreclosed real estate and also the branch facilities and land, whichwe are no longer utilizing. We expect to complete the sale of one more of thoseformer branch sites in the fourth quarter this year and are currently innegotiations for a possible sales agreement on the Heritage Place property. Thelikelihood of that sale being completed is unknown at this point.

We reviewed our construction loan portfolio in some detailduring the third quarter. Our review was primarily designed to review thosepre-sold loans to see what the condition of the permanent takeout on thoseloans was, whether the borrowers might be impacted by some of the fallout inthe mortgage industry.

Fortunately, we've identified only a very small group ofconstruction loans that were backed by these pre-sold permanent takeouts thatwe think have a likelihood of having problems closing into their permanentloans.

We're much more closely monitoring our spec residentialconstruction loans and have substantially tightened up the approval process forthose loans, with approval to come from at least one of our regionalpresidents, with no individual residential spec lending authority remaining inplace at this time.

We're also taking an even more stringent view of residentiallot development loans, given the increase in lot inventories that has occurredin our markets over time. Just to provide a little more detail on the makeup ofthat construction portfolio, we identified in the press release totalconstruction loans of about $920 million.

Just a little over 1% of that is in multifamily properties,between 13 and 14% is commercial properties of one type or another, about 44%is residential construction, and the remaining roughly 41% is in primarily landdevelopment or lot development loans.

From a state-by-state standpoint, just in fairly roundfigures, about 45% or so of the construction portfolio is in New Mexico.Probably, only about 3% or so is in Arizona. And then Colorado and Utah areroughly both about 27% or 28% each. So we are geographically fairly welldiversified there.

I think the market that we are watching most closely at thispoint is the Colorado market. New Mexico has been fairly steady, and ourexperience there has been good. Utah is a very strong market, with excellenteconomic characteristics at this point.

Colorado, although certainly not got suffering too badly,probably is slightly weaker than the New Mexico and Utah market. So we're goingto continue to take a close look at that Colorado portfolio, in particular,going forward.

We continue to look for new ways to reduce or control ourexpenses. These will come primarily from streamlined operational functions orbetter automation in a few cases. We believe right now that our stock iscurrently undervalued, considering the potential for improved performance andthe intrinsic value of our franchise.

Now, Chris will run through some of the detail on ourresults for the third quarter. And then I will come back and summarize a fewthoughts.

Christopher Spencer

Thanks, Pat. If you all have the slides up, I'll walkthrough those with you. Our total assets ended the quarter at just over $3.3 billion,including total loans of $2.478 billion, which is an increase year-to-dateafter taking the Heritage acquisition out of about $188 million.

So to take a look at a more organic growth rate annualizedthrough the third quarter, exclusive of Heritage, about a 12% annualized growthrate on the loans. On the quarter, it was a little bit less than that. On anannualized, third quarter is running about 7.5%.

For those interested in the balances by state, at the end ofSeptember, New Mexico total loans were $1.490 billion, Colorado were $632million, Utah was $258 million, and Arizona was $99 million. We had good growthin New Mexico, Utah as well as Arizona in the quarter. And Colorado actuallydecreased slightly, primarily because of the Heritage loan sale.

Taking a look at deposits. They ended the quarter at $2.548billion. Again, absent the Heritage acquisition, that's an increase of about$68 million year-to-date on an annualized rate of about 4.3%. But this isreally one of our highlights for the quarter.

And as many of you know, our deposit growth was basicallyflat the first half of the year. This third quarter, we saw a $64 millionincrease in our total deposits, which gives us for the quarter an annualizedrun rate of just a little over 10%. So we're real happy with our growth indeposits on the quarter.

Again, for those interested in the state-by-state numbers,at September 30, deposits for New Mexico were $1.798 billion, Colorado $605million, Utah $22 million, and Arizona $124 million. Again, we saw some fairlynice increases state by state. Particularly, Arizona continues to generate somevery good deposits relative to their size.

Breaking that down a little bit further. Ournon-interest-bearing deposits saw an increase as well of about $8 million inthe quarter. That's about a 6 -- a little over 6% annualized rate just takingthe third quarter. So we're pleased with the non-interest-bearing increases aswell.

Moving into the quarterly income and diluted earnings pershare, $0.32 on the quarter. Pat alluded to, I think, most of the things thatdrove the earnings in the quarter. I mean, obviously, we had pressure from themargin that drove down the earnings a little bit as well as lower levels ofmortgage volume in the quarter.

We sold $76 million of mortgage loans in the third quarter,which is down from $91 million in the second quarter and $102 million in thefirst quarter. So we, clearly, saw lower volumes given the overall mortgagemarket. And Pat also mentioned we had a loss on the redemption of some trustpreferred in the quarter as well, totaling $449,000.

Our net interest margin, again, 4.57% on the quarter, down 9basis points. We saw some impact of the latest Fed cut, but it's fairly minimalin the quarter. But we'll -- as Pat indicated, we'll see the majority of thatcompression come here in the fourth quarter.

Our return on average assets and average equity were 0.79%and 8.48% on the quarter. Our efficiency ratio for the quarter was 68.77%. Iwill point out the efficiency ratio is skewed a little bit by the unusual eventwith the trust preferred loss in the third quarter, and also point out in thesecond quarter it looked a little bit better because of the extraordinary --with all the insurance proceeds in the second quarter.

So if you take out those -- both those items, the secondquarter would have been 69.26 and the third quarter would have been 67.64. Sowe have seen a slight decrease absent those kind of unique items from second tothird quarter, which is what we anticipated, as we start to integrate and getHeritage integrated into our system. And I think we would anticipate a furtherdecline into the fourth quarter.

Obviously, that may be mitigated somewhat, as we continue tohave topline margin pressure as well as potential mortgage volume pressure. Butwe do think we will continue to see improvement in the non-interest expensearena.

Total non-performing assets as a percentage of total assetsat the end of the third quarter was 1.12% on total NPAs of $37.4 million. Wedid see an $18 million decrease from the second quarter, with $4.3 million ofthat a reduction of other real estate owned. In the quarter -- we did sell theErie branch in the quarter, which was on the books for $2.1 million.

We had a further write-down of the Heritage Place propertyup in Broomfield, Colorado, $1.3 million. And as we had indicated before, thereis a lot inventory that we foreclosed on previously that we sold but will betaken down over a period of time. We've got the first reduction payment on thatsale of $1.1 million, which accounted -- those three items account for themajority of our reduction in other real estate owned.

Our delinquent loans at the end of September were 0.97% oftotal loans at $23.9 million, relatively flat from the second quarter, upslightly, but no significant deterioration indicated by our delinquencies atthis point overall.

The allowance for loan losses ended the quarter at $29.6million, which represented 1.2% of total loans held for investment. And theallowance represents 158% of non-performing loans, which is up substantially onJune 30, primarily because of the loan sale. At June 30, the percentage ofnon-performing loans was 90%.

As far as the provision and the net charge-offs in thequarter, our charge-offs were up just over $2 million. There was four fairlysizable construction-related charge-offs in the quarter. But with that,year-to-date, our annualized charge-off percentage is about 17 basis points,which is equivalent to what it was for all of 2006. And that's kind of gettingback to what we think is a more normalized level of charge-offs anyway, butthey did rise fairly substantially over the first and second quarters of thisyear.

With that, I'll turn it back over to -- I guess, Pat willhave some more comments, and then we'll open it up for your questions.

H. Patrick Dee

Thanks, Chris. With the integration of the Front Rangeorganization now complete and the solid growth numbers that we achieved in thethird quarter, we believe, we're well positioned for stronger performance inthe quarters ahead. We'll continue to monitor and manage the credit risk in ourlending activities in an aggressive fashion.

Our markets continue to demonstrate solid population growthand generally good economic trends, although there is some weakness in theresidential housing sector. But all of that together leads us to believe thatwe can resume solid returns over time to our shareholders.

With that, we'll open it up to questions from our analysts.

Question-and-Answer Session


Thank you. We will now begin the question-and-answersession. (Operator Instructions) One moment please for the first question.

Our first question comes from Mr. Peyton Green. Sir, you mayask your question.

Peyton Green - FTN Midwest Securities

Good afternoon. I was wondering if you all could talk alittle bit about the efficiency efforts, given that you do expect marginpressure in the fourth quarter. About what degree were costs inflated in thethird quarter compared to what they might be in the fourth? Thank you.

H. Patrick Dee

Well, the single largest effect was the write-off of thecosts on the trust-preferred redemption. We did have a -- still a little bit ofexpense related to the Front Range acquisition, as we completed the conversionof that system. So there were a few conversion-related expenses and the finalseverance amounts paid to their employees associated with that.

We also had higher than normal operational losses with oneof those on the operational side of the Bank, another one in the mortgage area,that totaled about $230,000. So all of those things contributed to ahigher-than-normal efficiency ratio in the third quarter. Our approach, rightnow, is to continue to manage our expenses downward, both on purelydiscretionary expenses and also, most importantly, staffing.

We're continuing to identify areas in operational parts ofthe bank, where we can become more efficient by automating certain functions,in a few cases, eliminating some duplication of efforts.

And so we'll continue to manage that staffing number downover the remainder of this year. But the most important part of this is thatwe're going to be looking at several different opportunities for expense reductions,not just relying on one particular area for it.

Peyton Green - FTN Midwest Securities


Michael Stanford

Peyton, it's Mike Stanford. I think the other big shift thatyou'll find with this company that's taking place through these threeacquisitions and some work we've been doing is this is now a very strategicpiece of what we're doing. And it isn't just can we start cutting someexpenses. It's top of mind with everyone in the leadership group.

We've conducted studies on support operations and financeand accounting and just about every place through the company. So we've got aroadmap, and we've got that being put into the budgeting. And really it is morestrategic now than it ever has been in the company's history.

Peyton Green - FTN Midwest Securities

Okay. And I guess -- I mean, is it a number that rounds towhat the trust preferred expense was in the third quarter or is that a littlehigh maybe, just in terms of the fourth quarter?

H. Patrick Dee

I'm not sure I understand your question.

Peyton Green - FTN Midwest Securities

I guess if you mentioned you had about $450,000, another 230that you would expect to go away, any notion as to how high the severance wasthat you paid in the quarter or any of the Heritage-related expenses that willgo away?

Christopher Spencer

Let's say when you add those all together that probablyequates to about what the trust redemption loss was. So I'd say the numberwould push $900,000 to $1 million all told with the trust loss (ph).

Peyton Green - FTN Midwest Securities

Okay. And then in terms of the new branches that you'vecommitted to, how many more of those are left to open?

H. Patrick Dee

We opened one new one in Albuquerque the 1 of October, butat the same time have closed a couple of branches that netted as a netreduction of one in that move. The only other new branch that we have on thetable at this point is one for Las Cruces, probably, going to open late firstquarter or early second quarter of next year. If we add anymore beyond that,it's probably late 2008 at the earliest.

Peyton Green - FTN Midwest Securities

Okay. And then in terms of the effort that you've made inrealigning the compensation of your commercial bankers, what did you see in thethird quarter that gives you optimism and where you're tweaking things in termsof getting the right behavior in terms of production and quality?

H. Patrick Dee

There will be -- the incentive payments going to these commerciallenders are based, first and foremost, on their new loan production as well assome quality measures related to overall asset quality and creditadministration.

We think that plan has them focused on generating both newloan volume that's of a high quality as well as generating some additionaldeposit business for us. We will continue to tweak that, as we go forward. Butto date, I think, the results have been pretty positive there.

Peyton Green - FTN Midwest Securities

Okay. Great. Thank you.


(Operator Instructions) Mr. Spencer, at this time, we haveno more -- no further questions.

Christopher Spencer

Okay. Pat, any other?

H. Patrick Dee

Well, we certainly appreciate everybody's attention today.Clearly, the banking environment right now has some challenges. In our case, wethink, the two major ones that we have addressed are controlling our netinterest margin, which we think is extremely important despite the rate cuts orthe one rate cut and the anticipated additional rate cut from the Fed.

We think we'll maintain a very strong net interest margindue to our good core deposit growth, which again, hopefully, we've seen a trendstart to develop there in the third quarter with better core deposit growth andat the same time continuing to generate some good loan volume. So although weexpect some further contraction in our interest margin, we feel very positiveabout the strength of that particular figure going forward.

Clearly, asset quality is on the forefront of everyone'smind at this time in the banking world. We have done a lot. We will continue tofocus on maintaining good asset quality and making sure that we're underwritingrisk appropriately going forward.

Clearly, in the past, we've seen a great deal of income comeout of the construction and land development area. We think that can continueto be good business for us, but we're going to have to manage and underwritethat risk a little more aggressively than we have in the past.

Clearly, our expense levels, even with the reductions thatwe've seen this year, are higher than we expect them to be going forward. We'regoing to focus a tremendous amount of effort in managing that efficiency ratiodown over the next year, in particular.

We have done a lot of things to help us in that process.We've done some minor reorganizing of our organizational structure within thecompany to assist in that effort. And we think we have a management team thatcan help us accomplish all of those things very effectively for ourshareholders over the near term.

Again, as I said before, we think, our stock is currentlyundervalued at its present level. We think, once we get past the yearendresults, give the market a chance to get over its jitters relative to asset qualityand demonstrate a little better performance both in asset quality and expenselevels, that we think we'll see a return to more normal levels for our stockprice.

As always, we appreciate the support of our shareholders.And with that I guess we'll wrap up our call for today. Thank you.

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