Heartland Financial USA Q3 2007 Earnings Call Transcript

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Heartland Financial USA Inc. (NASDAQ:HTLF) Q3 2007 Earnings Call October 29, 2007 4:00 PM ET

Executives

Leslie Loyet - IR

Lynn Fuller - President and CEO

John Schmidt - COO and CFO

Analysts

Jeff Davis - FTN MidwestSecurities

Brad Milsaps - Sandler O'Neill

Jon Arfstrom - RBC Capital Markets

Brian Martin - Howe Barnes

Operator

Good afternoon, ladies and gentlemen, and thank you forstanding by. Welcome to the Heartland Financial USA Third Quarter 2007 ConferenceCall. During today's presentation, all parties will be in a listen-only mode.Following the presentation, the conference will be open for questions.(Operator Instructions). This conference is being recorded today, October 29,2007.

I would now like to turn the conference over to LeslieLoyet, from Financial Relations Board. Please go ahead.

Leslie Loyet

Thank you. Good afternoon, everyone. Thank you for joiningus for Heartland Financial USA's conference call to discuss third quarterresults. This morning, we distributed a copy of the price release, andhopefully you've all had a chance to review the results. If there is anyoneonline who did not receive a copy, you may access it at Heartland's website atwww.htlf.com, or you may call Han Huie at 312 640 6688, and she will send you acopy immediately.

With us today from management are Lynn B. Fuller, Presidentand Chief Executive Officer, and John K. Schmidt, Chief Operating Officer andChief Financial Officer. Management will provide a brief summary of the quarterand then we will open the call up to your questions.

Before we begin the presentation, I would like to remindeveryone that some of the information that management will be providing todayfalls under the guidelines of forward-looking statements as defined by theSecurities and Exchange Commission. As part of these guidelines, I must pointout that any statements made during this presentation regarding the company'shopes, beliefs, expectations or predictions of the future are forward-lookingstatements, and actual results could differ materially from those projected.

Additional information on these factors is included fromtime to time in the company's 10-K and 10-Q filings, which can be obtained onthe company's website or the SEC's website.

At this time, I would like to turn the call over to LynnFuller. Please go ahead.

Lynn Fuller

Thank you, Leslie, and good afternoon everyone. We certainlyappreciate everyone joining us this afternoon; I assume you all have had anopportunity to review Heartland's third quarter earnings release that wasissued this morning.

Today, Heartland reported year-to-date 2007 earnings of$18.9 million, or 7.5% over the previous year, and third quarter earnings of$6.9 million, matching last year's quarter. Diluted earnings per share are$1.14 year-to-date compared to $1.05 last year. So a nice increase in EPSyear-to-date, and $0.42 for the third quarter, compared with $0.41 for theprevious year's quarter.

Let's start out with the positives, as several areas of ourperformance stand out as positives. First, earnings from continuing operationsare up year-to-date and quarter-over-quarter. Second, non-interest incomecontinues to show very good increases, growing 6% for the quarter and 10%year-to-date.

Next, non-interest expense continues to moderate, growing byonly 8% over last year despite the opening of five new banking locations. Andfinally, loan and deposit balances are both showing good growth increasing by8% and 6%, respectively, on an annualized basis.

Now, these positive earnings and growth performancehighlights are tempered to some degree by a decrease in our net interest marginand an increase in our nonperforming loans, which grew from $19 million to $30million during the quarter. This increase is primarily in four credits, ofwhich one has already been brought current and back on accrual. We believe theslowing economy has, at least in part, contributed to this increase innonperformers.

During our second quarter conference call, we described somesoftness in our Wisconsin markets, wherenearly half of our nonperforming loans reside. You may also recall that duringthe second quarter we had substantial provision expense in anticipation ofprobable losses in these credits; as a result, this quarter's provision expenseis down substantially, as we believe we are adequately reserved.

John Schmidt, Heartland's CFO and Chief Operating Officer,will provide further color on our financial results in a few minutes. Butfirst, I would like to describe some of our recent expansion activities.

In September, Rocky Mountain Bank opened a second office in Billings, Montanato take advantage of expected growth in the city's west side. Just last week,Arizona Bank & Trust opened its sixth location in the Southeast Valley ofPhoenix with an office in Gilbert. This is another burgeoning community thatoffers exceptional opportunity for both our business and retail banking lines.

In Colorado, Summit Bank & Trust is putting thefinishing touches on a new office in the community of Erie with an opening planned for next week.This location was recently purchased from another financial institution andprovides an excellent opportunity to take another step forward in rounding outour Northern Front Range presence in the Denvermarket with three banking locations.

For some time now, we've expressed an interest in charteringa new bank in Minneapolis, Minnesota. This Midwestmarket provides exceptional growth dynamics and is dominated by large regionaland national banks, a market environment we find attractive. Heartland hasjoined with the local investor group who will own 20% of the bank. The bankwill be capitalized at $16 million. Kate Kelly, an experienced and visiblelocal banker, will serve as President of Minnesota Bank & Trust,Heartland's tenth bank.

We are excited about the prospects of competing in the TwinCities market and are planning to ramp-up our presence with a loan productionoffice in Edina,the location of the bank's proposed main office. Our goal is to open MinnesotaBank & Trust in the first quarter of next year.

With the opening of Minnesota'sLPO late this year, Heartland's footprint will expand to eight states with 60banking offices serving 41 communities. At this juncture, our branch expansionplans for next year are to construct three new offices, down from fiveadditions this year, one in New Mexico, one inArizona, and a second location in the Minneapolis area.

Looking ahead to the fourth quarter and beyond to 2008, ourfour top corporate objectives are: number one, same-store growth of coredeposits and quality loans; number two, a mandate to cleanup nonperformingloans, cutting our nonaccruals in half; three, managing our net interestmargin; and four, controlling non-interest expense through the implementationof workplace lean, a product of Six Sigma, an initiative to streamlineprocesses and eliminate redundancies, which we believe will reduce cost whileimproving service to our valued customers.

Well, that concludes my comments. I will now turn the callinto John Schmidt for more detail on our third quarter and year-to-datefinancial results. John?

John Schmidt

Thanks, Lynn,and good afternoon. As in the past, I will provide additional details on thismorning's press release. Emphasis will be given to the most substantial changesto our balance sheet and income statement in the past quarter, 9/30/07 versus 6/30/07.

Looking first at the balance sheet, loan balances decreasedby $24.1 million in the third quarter as the availability of quality new loanshave been reduced at this point in the credit cycle. Additionally, the time ourlenders spend collecting nonperforming assets also impacts production. At thesame time, year-to-date loan growth stands at $98 million and $119 million whenthose loans sold at the Broadus, Montanalocation are included.

Looking ahead, it is likely that we will be moving $16million to $20 million of underperforming, although still accruing, credits outof the organization in the fourth quarter. Additionally, early in the fourthquarter, we entered into an agreement to sell $6 million of portfolio loans. Asa result, we are scaling back our forecasted annual loan growth to $110 millionfor the year ended 12/31/07. This number excludes $28 million of loans movedfrom available for sale in the portfolio as of 6/30/07.

Net charge-offs for the quarter totaled $1.9 million and$5.2 million from a year-to-date perspective. Total net charge-offs to date,expressed as a percentage of average loans and leases, totaled 23 basis points.We feel we should see a moderation in the amount of charge-offs for the balanceof 2007.

Relative to nonperforming loans of this quarter's increase,a third of the dollars have returned to accrual status. You'll also recall fromlast quarter that $4 million of the total nonperforming loans were loans thatwere guaranteed by the USDA and SBA and previously sold to the secondary marketand then subsequently repurchased. While we're very focused on resolving ournonperforming credit issues, given that some of these nonaccrual loans are realestate loans, they will take longer to work out of our system.

Finally, I'd like to point out that our allowance for loan lossmethodology remains consistent with previous quarters.

Moving to core deposits, core deposits, excluding brokeredCDs in this case, grew $57 million for the third quarter, representing anannualized growth rate of 10%. While deposit growth is typically stronger inthe third quarter this reflects one of our key strengths of our organization.We continue to view the growth of our deposit base as a focus for all of oursales personnel, both loan and deposits.

As Lynnmentioned, net income totaled $0.42 per basic and diluted share. Theapproximately $0.01 dilution we've experienced for the past several quartershas been effectively eliminated as management found a decrease in stock priceto be an opportunity to exercise stock options.

The company's net interest margin was 3.87 for the quarter,which is a 15 basis point decrease from the quarter ended 6/30/07. During thelast conference call, we forecasted that our margin would drop to 3.95%. The 8basis point differential between the expected amount and our actual results canbe explained by the following factors: one, loans being placed in nonaccrualstatus impacted margin by 4 basis points; the reduction of $24 million in loanswith a margin impacted by the difference between the rate earned on loans andFed funds added an additional 2 basis points.

Finally, the addition of $20 million in bank-owned lifeinsurance mentioned last quarter, the funding of which impacts interest expensewhile the corresponding earnings are reflected in non-interest income,contributed an additional 2 basis points, arriving at the 8 basis points that Imentioned.

Going forward with the opportunity to reprice about 77% ofour CD portfolio in the next year at rates slightly lower than the current4.87%, we see a relative stabilization of the margin. At the same time, we doremain asset sensitive, thus, an additional Fed rate cut would have a negativeimpact on our margin.

Non-interest income continues to reflect solid improvementover last year and consistent strength versus last quarter results. The mostnotable change was the impact of the previously mentioned increase in theamount of bank-owned life insurance on our books. This increase combined with ahigher return on the underlying policies, contributed $278,000 to the increasein non-interest income for the quarter. The previously mentioned sale of $6 millionof portfolio loans should result in a gain of approximately $1 million, whichwill be reflected in the fourth quarter.

We were also very pleased with the continued stabilizationof non-interest expense, which ended the quarter at $24.7 million, $182,000 or1% decrease from the second quarter. Even considering the cost to ramp upMinnesota Bank & Trust, we expect that expenses will remain relatively flatduring the fourth quarter.

With that I will open up for questions.

Question-and-AnswerSession

Operator

Ladies and gentlemen, at this time we will begin thequestion-and-answer session. (Operator Instructions). Our first question comesfrom the line of Jeff Davis with FTN Midwest Securities. Please go ahead.

Jeff Davis - FTN MidwestSecurities

Good afternoon. John or Larry, if I can get you to commenton perspective on performance of the individual subsidiaries what was -- whowas strong, who wasn't, and maybe looking forward, and why? And then secondly,John, the $1 million gain for the fourth quarter, is that likely to be offsetby elevated expenses or one-time items?

Lynn Fuller

Jeff, this is Lynn.The Western banks of New Mexico Bank & Trust in Montana are showing very good performance.The other two banks south west, Arizona and Denver, are close to theirbudgets, a bit under at this point, but both are still in their first fiveyears of operation de novo banks. So, we've been expanding them ratheraggressively, as I shared with you. Dubuquecontinues to be a solid performer, albeit a bit behind where they were lastyear. The banks that are struggling this year would be: Wisconsin,Riverside, and Rockfordand Galena hadthat one-off lost that hit us last quarter. And John I don't know if you've gotmore to add to that.

John Schmidt

No, that's a pretty good summation. I think the other one,First Community in Keokuk, Jeff, remains, actually it was one of the topperformers in the group. And just to add color on Galena, aside from that one loss, theirperformance is very much -- they are very solid, consistent with last year, letme put it that way.

Relative to your second question, the costs anticipated onthe conversion of that portfolio is right around about $200,000.

Jeff Davis - FTN MidwestSecurities

Okay, thank you.

Operator

(Operator Instructions). Our next question comes from theline of Brad Milsaps with Sandler O'Neill.

Brad Milsaps - SandlerO'Neill

Hi, good afternoon.

Lynn Fuller

Hi Brad.

Brad Milsaps - SandlerO'Neill

Just to follow up to Jeff's question in terms of theindividual banks, I think last year, initially the de novo in Colorado lost about $1.2 million in thefourth quarter. Is it your sense that you'll be able to get Minneapolisoff the ground maybe a little bit better than that or is that a pretty goodblueprint for us to look at in terms of how Minneapolis, at least, is going to play outin the near-term?

John Schmidt

You know, Brad, I think we still look at the de novo modelthat we put in place, given the ramp up in personnel and having quality peoplein place. We look to have a $1 million loss in that first year, not necessarily,I think you said quarter, but the first year loss will be a run of about $1million, if not just a little bit north of that. So again, that's the way we'vebuilt them historically. I think it's having the quality people on the groundfirst. Certainly, we would like to see a ramp up and portfolio maybe a littlebit faster but that's what we would anticipate from Minnesota Bank & Trust.

Brad Milsaps - SandlerO'Neill

Okay, fair enough. Thank you.

Operator

Your next question comes from the line of [Shawn Collins]with RBC Capital Markets.

Jon Arfstrom - RBCCapital Markets

Hi guys, its Jon Arfstrom.

Lynn Fuller

Hi Jon.

Jon Arfstrom - RBCCapital Markets

Hi. A couple of questions for you. The securities growth thatwas up a little more than we expected, John, just curious what the appetite isthere?

John Schmidt

No, I think the -- certainly the reduction of the loanbalances Jon that was an opportunity that we saw to move into the securitiesarea. Certainly, there was a sell-off in some sectors of the market or the bondmarket as a whole, which we took advantage of. I think we were very pleasedwith what we were able to roll into on the securities side.

Jon Arfstrom - RBCCapital Markets

All right. And then can you talk a little bit about thecomponents of the nonperformers in terms of the size of the credits that are inthere and the types?

John Schmidt

You know, I think last quarter we talked about one largecredit, certainly, in Wisconsin;it was about $7 million. I would say as a rough estimate maybe from a macroperspective, Jon, we could say, of the $30 million that could be accounted forin eight credits or so, kind of back on napkin approach, but it isn't a huge numberof credits. Rather, it's just fairly contained in, as I said, eight credits ofany real size.

Lynn Fuller

A common thread that runs through those credits, Jon, isthat, for the most part, they are backed up with pretty good low LTVs on thereal estate. That's why it's going to take us some time to work through them.We have got some condo projects in Wisconsin.We had one large credit that we talked about last quarter in Galena that was not backed by real estate,but for the most part, we've done a good job of taking collateral. We think weare in the assets right. It's just going to take us some time to foreclose themout or move them out.

Jon Arfstrom - RBCCapital Markets

Fair enough.

John Schmidt

Jon, just a little more color,seven of the -- there are seven credits over $1 million in that $30 milliontotal, one credit alone that was just added was $5 million.

John Arfstrom - RBC Capital Markets

All right, good. That's helpful.A little bit on the loan pipeline -- can you talk about how that feels, andthen your comments about a little bit slower loan growth? I think we allunderstand it. How much of it would you say is the market that you're ingenerally being slower, and how much of it is your own cautiousness?

John Schmidt

I think that the first thingwould be probably the markets we are in. We aren't seeing the number of deals,good deals that we want to pursue as we had in the past. I think this is totallyreflective of the economy. Certainly, we're cautious, but I don't think we areoverly cautious at this point. We are still willing to do good deals. I thinkthe fourth quarter is we're moving some credits out; we're putting togetherbudgets for '08 now. We still look to have reasonable loan growth for '08. It'sstill always unknown being what's going to happen to the economy and how far itwill swing.

John Arfstrom - RBC Capital Markets

And I guess the last question isfourth quarter of '06, you had some payouts in your loan portfolio if you goback through the notes, and I'm just curious what your outlook is in terms ofthat type of activity at the end of the year. Is that just something we shouldnaturally expect?

John Schmidt

The first thing that comes tomind is certainly the Ag portfolio. I think we are in a stream of about $5.4million reduction in the Ag portfolio in Q4. The Ag sector I think remainspretty darn strong at this point. Other than that, I mentioned $16 million to$20 million of loans that we are moving out. Those are loans we do want to moveout. They are currently on accrual. I want to make sure everybody understandsit. They aren't in that $30 million total, but they are an additional $16million to $20 million of loans we'll be moving out. So, I still forecast loangrowth in Q4 certainly not as robust as it's been but understand the offsets.

Lynn Fuller

John, I would say I wouldcharacterize 2007 as a year that we have aggressively moved some credits outthat were refinanced at other financials. We've also seen normal pay downs on afair number of credits.

So, the production that we've hadhas been reasonable, but we've had to replace a lot of credits that were eithermoved out or credits that were just normally paid off.

John Arfstrom - RBC Capital Markets

Okay, thank you.

Operator

(Operator Instructions) Our nextquestion comes from the line of Brian Martin with Howe Barnes.

Brian Martin - Howe Barnes

Hi, guys.

Lynn Fuller

Hi Brian.

Brian Martin - Howe Barnes

John, can you just give a littlecolor? Your residential development exposure, how big is that?

John Schmidt

Residential development loan,Brian?

Brian Martin - Howe Barnes

Right.

John Schmidt

I don't have that figure rightnow, but if I had to guess, it would be in the $50 million to $70 millionrange.

Brian Martin - Howe Barnes

Okay, and most of that being inthe Midwest, or more out West?

John Schmidt

Probably more out West than in Midwest.

Brian Martin - Howe Barnes

And net portfolio, is itperforming pretty well at this point?

John Schmidt

Yes, I think by and large. Wedon't have any non --

Lynn Fuller

We have one credit, one credit inMontana thatis a residential development, but other than that, the rest of them are alldoing well. They are still performing; that's a performing asset.

John Schmidt

I don't think we have anyresidential developments right now, Brian that are non-performing.

Brian Martin - Howe Barnes

Okay. All right, how about, thetax rate? What is a good level to be using as we go forward here, given some ofthe things that have impacted it this year? Can you --

John Schmidt

Yes, I see and as you saw in therelease, certainly the purchase of those credits kind of makes it a littledifficult to track exactly where the marginal tax rate is, if I call it that. Istill think, if you use 31.5%, 32%, you're probably in a decent range on that.

Brian Martin - Howe Barnes

Alright, and lastly, Lynn talked a little bitabout his four objectives for next year. Can you just talk a little bit aboutthe expense line item or the expense objective and kind of what your thoughtsare -- what your expectations are there -- kind of what you're planning in ondoing there?

Lynn Fuller

As far as the implementation ofworkplace lean and other initiatives?

Brian Martin - Howe Barnes

Exactly.

Lynn Fuller

We don't have a hard number,we're going through the budgets right now. But the obvious is that if we can'tgrow our earnings base at the level we would like to, and if margins shrink,the only place left to look is in overheads. So, if it means we will have toaddress salaries and our variable expense on bonuses, we will go there.Otherwise, we will have a number of initiatives underway next year which willbe part of our budget, and I just don't have the numbers for you on those yet,Brian. But there will be a number of initiatives that will be underway withworkplace lean.

Brian Martin - Howe Barnes

Okay. I guess, if you can't getthe growth in what you're looking for, it won't prevent you from opening theoffice that you are shooting for. I mean, it would be other items outside ofthat, correct?

Lynn Fuller

Yes. Well, as I said, we've onlygot three new offices planned for next year, compared to the five we openedthis year. The last three years, we've had pretty aggressive branch openings.So that's going to be trimmed back a bit, and we are hoping to get some costsavings out of workplace lean.

John Schmidt

Brian, it is not that this iscertainly a knee-jerk reaction to any –

Brian Martin - Howe Barnes

Right, no, I didn’t [inaudible]

John Schmidt

So, we've been working throughand getting ready for workplace lean, as Lynndescribed for quite awhile. So this is just the next step in that, and it seemsto coincide very well with where we are in our stage of evolution.

Brian Martin - Howe Barnes

Alright, I understand. Okay,thanks guys.

John Schmidt

Thanks.

Operator

Mr. Fuller, there are no furtherquestions at this time. Please continue with any closing remarks.

Lynn Fuller

Very good. Thank you. I guess, insummary, Heartland's financial performance remains solid with continued EPSgrowth, and that's an objective that we will continue to focus on. We've haddecent balance sheet growth and solid noninterest income growth and a levelingoff of non-interest expense. As I said, we will be working on some projectswith workplace lean to continue to control our non-interest expense. I want tothank everyone for joining us today and hopefully, you can join us again forour next quarterly conference call, which will be January 28 of next year.Thanks again. Have a good evening.

Operator

Ladies and gentlemen, thisconcludes the Heartland Financial USA third quarter 2007 conference call. Thankyou for your participation. Thank you for using ACT Teleconferencing. You maynow disconnect. Have a pleasant day.

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