Heartland Financial USA, Inc. (NASDAQ:HTLF) Q2 2023 Earnings Conference Call July 31, 2023 5:00 PM ET
Company Participants
Bruce Lee – President & Chief Executive Office
Bryan McKeag – Chief Financial Office
Nathan Jones – Chief Credit Officer
Conference Call Participants
Jeff Rulis – D.A. Davidson
David Long – Raymond James
Andrew Liesch – Piper Sandler
Terence McEvoy – Stephens
Damon DelMonte – KBW
Operator
Greetings, and welcome to HTLF’s 2023 Second Quarter Conference Call. This afternoon, HTLF announced its second quarter financial results, and hopefully, you’ve had a chance to review the earnings release that is available on HTLF’s website @htlf.com. With us today from management are Bruce Lee, President and CEO; Bryan McKeag, Chief Financial Officer; and Nathan Jones, Chief Credit Officer. Management will provide a summary of the quarter, and then we will open the call to your questions.
Before we begin the presentation, I would like to remind everyone that some of the information provided today falls under the guidelines of forward-looking statements as defined by the Securities and Exchange Commission. As part of these guidelines, 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 may be obtained on the company’s or the SEC’s websites.
I will now turn the call over to Mr. Bruce Lee, HTLF President and CEO. Please go ahead, Mr. Lee.
Bruce Lee
Thank you, Abigail. Good afternoon, everyone. This is Bruce Lee, President and CEO. Welcome to HTLF’s 2023 Second Quarter Earnings Conference Call. I appreciate you joining us today as we discuss our solid performance and momentum heading into the second half of the year. For the next few minutes, I’ll discuss HTLF’s highlights for the quarter then turn the call over to Bryan McKeag, Chief Financial Officer, for more details on our performance and financials. Also joining us today is Nathan Jones, Chief Credit Officer, who can answer questions regarding the stable credit quality across our portfolios.
The HTLF Board of Directors approved a quarterly cash dividend of $0.30 per share on the company’s common stock payable on August 25, 2023. The Board also approved a dividend of $175 for Series E preferred stock, which results in a dividend of $0.4375 per depository share, payable on October 16, 2023. For more than 40 years, HTLF has increased or maintained our common stock dividend each quarter. This reflects our strength and stability and confidence in our strategies and performance. In the second quarter, HTLF’s strength and diverse geography enabled us to continue executing our strategies despite recent industry challenges. We delivered strong loan growth and new customer relationships. And our stable deposit base and growth strategies give us momentum heading into the second half of the year.
For the quarter, net income available to common stockholders was $47.4 million, an EPS of $1.11. These numbers were negatively impacted by two items: a charge-off of $5.3 million related to a previously disclosed overdraft, the result of a fraud incident impacting the account of a single long-time customer; and $1.5 million of premium write-offs related to an unusually high level of purchased SBA loan payoffs that were processed during the quarter. These were partially offset by the $4.3 million gain from the sale and transfer of the recordkeeping and administration services component of our retirement business to July Business Services. We view these as notable items this quarter. Together, they decreased pretax income by $2.5 million and EPS by $0.05.
Our growth strategies are delivering results. In the second quarter, HTLF added new customers, delivered solid loan growth and significantly increased fee income. From the linked quarter, we added 1,300 net new commercial accounts and more than 1,400 net new consumer accounts. Commercial and ag loans grew $224 million or 2%, and loan yields increased 44 basis points on newly originated loans. Service charges and fees increased $2.5 million or 15%, including an annual Visa incentive of $1.6 million, and capital markets fees increased $1.6 million or 65%.
Customer deposits were flat and expenses were slightly elevated, including a $1.1 million increase in advertising spending. We continue to strengthen our balance sheet and increased borrowing capacity by more than $500 million to a total of $3.3 billion with less than $1 million outstanding. Our capital ratios, including all unrealized gains and losses as of June 30, exceeded all well-capitalized regulatory ratios. Bryan will go into more details.
Let’s start with deposits. HTLF’s banks have a diverse and granular deposit base. As a result of our strategic diversification, our customer deposits are diversified by both geography and industry with no industry concentration higher than 10% across our portfolios. Overall, total deposits for the quarter were flat from the linked quarter at $17.7 billion, and 66% of total balances are insured or collateralized. Total customer deposits were also flat from the linked quarter. While we maintain a favorable deposit mix, customer demand accounts decreased from 35% to 34%, which reflects the ongoing transition to interest-bearing accounts.
We’ve launched a commercial deposit campaign with enhanced customer outreach and product offerings in small business and commercial. The campaign drove new commercial deposit balances in the second quarter, and positive trends have continued in July. With increased marketing spend resulting in additional customer contact and accounts opened, we’ve also continued our consumer deposit campaign that launched late in the first quarter.
Turning to loans, in the second quarter, we saw continued strength across our commercial loan portfolios. From the linked quarter, commercial and industrial increased $92 million or 3%; owner-occupied real estate increased $86 million or 4%; non-owner-occupied real estate increased $109 million or 5%; construction decreased $89 million or 8%; and our ag portfolio increased $30 million or 4%.
In total, commercial and ag loans grew $224 million, an increase of 2% from the linked quarter and in line with our guidance. 58% of loan production was commercial and industrial and owner-occupied real estate. We delivered loan production across all of our regions, with particular strength in the West, Mountain West and Southwest.
In the second quarter, we added more than 300 new commercial relationships, representing $214 million in funded loans and $48 million of new deposits. On average, new originations were higher credit quality than the overall portfolio as measured by risk ratings and credit scores, and 81% of these loans have variable rate structures, an increase from 75% in the first quarter. Our commercial pipeline remains strong at over $1 billion, with 60% in commercial and industrial and owner-occupied real estate. Loans are distributed across all regions. Our consumer loan portfolio increased $11 million or 2% from the linked quarter, while residential mortgage decreased $13 million or 2%. We expect total loan growth of $150 million to $200 million in the third quarter, which we expect to substantially fund through customer deposit growth.
Turning to key credit metrics, our disciplined credit approach is delivering stable credit quality across our portfolios. Delinquency ratio remains low at 12 basis points. Non-performing assets as a percentage of total assets remained flat at 33 basis points. Non-pass-rated loans increased slightly from the linked quarter to 4.8%. And excluding the previously disclosed $5.3 million overdraft, remaining net charge-offs were $4 million, most of which had been previously reserved in the prior quarters. Market conditions have been applying additional pressure on the commercial real estate office market across the country. We feel good that our office exposure is 3.5% of our total portfolio. We continue to place emphasis on targeted reviews of our portfolios and recently conducted in-depth reviews of each office credit over $1 million.
We believe our portfolio is well constructed, granular and generally situated outside of central business districts. We continue to enhance our ongoing portfolio management and surveillance and refine how we screen new opportunities for underwriting. For more on our CRE office exposure, please see Page 21 in the investor deck.
HTLF is executing our strategies and delivering new customers, new deposit relationships, strong loan growth, increased fee income, stable credit quality, and we’re driving long-term efficiency. Bank charter consolidation continues on budget and on schedule. We started at the beginning of 2021, and we expect to finish early in the fourth quarter. We’ve successfully consolidated 9 of our 11 banks today, demonstrating we can consolidate charters to drive greater internal efficiency while delivering external growth.
We also enhanced the products and services offered by our Retirement Plan Services business through our partnership with July Business Services. HTLF sold the recordkeeping and administration services business to July and retained investment management oversight in participant education and support business. The transaction was completed, and recordkeeping services were transitioned in the second quarter. Both firms are stronger together as July’s technology enhances the customer experience.
Our strategies and accomplishments continue to be recognized locally and nationally. Nielsen report ranked HTLF among the top U.S. commercial credit card issuers for the eighth year in a row. We continue to demonstrate consistent strength in the commercial payments space as HTLF saw a 30% increase in purchase volume growth in 2022. Last year, HTLF surpassed $1 billion in annual purchase volume as a commercial credit card issuer, and we continue to be one of the fastest-growing Visa commercial card issuers.
HTLF earns this recognition each year through our employees’ dedication and commitment to serving our customers, communities, shareholders and each other. We consistently deliver strength, insight and growth during good and challenging times. Together, we are HTLF.
I’ll now turn the call over to Bryan McKeag, Chief Financial Officer, for more details on our performance and financials.
Bryan McKeag
Thanks, Bruce, and good afternoon. As Bruce described, we continue to move forward in a challenging environment this quarter, reporting earnings per share of $1.11, loan growth of over $220 million and a stable, albeit more costly deposit base. In addition to the items Bruce mentioned in his comments, I would mention two other items this quarter: the charter consolidation restructuring cost of $1.9 million and the $300,000 of loss on sale of securities. Before I go into more detail, I want to remind everyone that our second quarter earnings release and investor presentation are both available in the IR section of HTLF’s website.
I’ll start my comments with the provision for credit losses, which totaled $5.4 million, or $2.3 million higher than last quarter. This quarter, the provision, consistent with last quarter, incorporates an economic outlook that anticipates a moderate recession developing over the next 12 months. Net charge-offs increased this quarter to $9.3 million, $5.3 million of which is related to the previously mentioned customer overdraft and directly impacted the provision.
Most of the remaining $4 million had previously been reserved for in prior quarters and as such, did not impact the provision. At the end of the quarter, total allowance for lending-related credit losses, which includes both the allowance for credit losses on loans and unfunded commitments, decreased $4 million to $129.8 million or 1.1% of total loans compared to 1.16% last quarter.
Moving to the balance sheet, Bruce already discussed loans and deposits, so I’ll start with investments. Investments declined almost $300 million to $6.7 billion, representing 33% of assets with a total — with a tax equivalent yield of 3.87% and will generate cash flows of nearly $1.3 billion over the next 12 months, with approximately $250 million next quarter. The unrealized loss on the AFS portfolio worsened by $43 million this quarter to $618 million. Our relatively small HTM portfolio of $835 million or 12% of investments has an unrecorded negative fair value mark of $28 million. We utilized nearly $250 million of cash flow this quarter from the investment portfolio to fund loan growth and pay down borrowings.
Moving on to borrowings, total borrowings declined $48 million to $417 million or 2.1% of total loans — or total assets, sorry. The reduction was primarily in customer repos, and we had less than $1 million of Fed advances outstanding at quarter end. To summarize our liquidity profile at quarter end, we have $1.3 billion of cash flow coming off our securities portfolio over the next 12 months with $250 million next quarter. We have a low level of outstanding borrowings and $3.3 billion of available capacity at the Fed and FHLB. We have several Fed fund borrowing lines and broker deposit sources that remain open and available.
Our customer deposit base is granular and well diversified with over 66% of balances either secured or collateralized. Our loan-to-deposit ratio was 66%, and when removing wholesale deposits, it remains low at 80%. We have cash and unpledged available securities totaled — totaling over $4.1 billion, and lastly, the holding company cash position stands at $268 million or 3.5x our current annualized interest and dividend payments. In addition, our dividend payout rate is relatively low at 27% of current EPS.
With regards to capital, regulatory capital ratios remained strong with common equity Tier-1 at just over 11.3% and total risk-based capital of nearly 15%. Adjusted for unrealized losses on our investments, the ratios remain above well-capitalized level at approximately 7.4% and 11%. The tangible common equity ratio increased 14 basis points to 5.86% at quarter end. The decline in market values of investments was partially offset by an increase in fair value swaps this quarter, resulting in a net decrease of 6 basis points from accumulated other comprehensive income or AOCI.
Moving to the income statement, starting with revenue, net interest income totaled $147.1 million this quarter, which was $5.1 million lower than the prior quarter, and the net interest margin on a tax equivalent basis fell 16 basis points this quarter to 3.24%. The main drivers of the decrease were $1.5 million of premium write-offs related to a higher level of purchased SBA loan payoffs that were received and processed during the quarter, which reduced NIM, net interest margin, by three basis points; and a continued shift in deposit balances from lower costing non-maturity deposits to much higher costing time deposits reduced net interest income by nearly $2.5 million and decreased net interest margin by five basis points.
Non-interest income of $32.5 million this quarter was up $2.5 million from the prior quarter. Excluding security losses, core noninterest income was up $1.9 million to $3.8 million, which exceeded our expectation of $30 million to $31 million. Strong capital markets fees were primarily a driver again this quarter. Shifting to expenses, non-interest expenses totaled $109.5 million this quarter. That’s down $1.6 million from last quarter.
Excluding restructuring, tax credit costs and asset gains and losses, the run rate of recurring operating expenses increased $3.1 million to $110.8 million, coming in higher than our forecasted $108 million to $109 million. The increase was driven by $1.1 million higher deposit-related advertising costs and a $2.4 million increase in professional fees due to several items, most notably higher legal costs for credit issues and an increased consulting activity level compared to last quarter.
Looking ahead to the rest of 2023, HTLF expects to see loan growth of $150 million to $200 million, or 2% per quarter, and customer deposit growth of $100 million to $150 million, or 1% per quarter. Achieving these loan and deposit growth expectations would enable the bulk of investment cash flows to be available to decrease wholesale deposits.
The net interest margin is expected to stabilize near our June run rate in the low to mid-3.20s on a tax equivalent basis. Provisions for credit losses are projected to range from $3 million to $5 million per quarter. Obviously, any declines in market conditions and projections could impact future provisions if a worse than moderate recession develops or credit quality metrics decline significantly.
Core noninterest income, that is excluding investment gains and losses, is expected to be $31 million to $32 million per quarter. Recurring operating expenses are expected to be in the $109 million to $110 million range per quarter. Our charter consolidation restructuring costs are forecasted to be between $2.5 million and $3 million per quarter for the next 2 quarters. And finally, we believe a tax rate in the 23% to 24% range, excluding new tax credits is a reasonable run rate.
And with that, I’ll turn the call over to Bruce.
Bruce Lee
Thank you, Bryan. Abigail, I think we’re ready to open it up for questions.
Question-and-Answer Session
Operator
[Operator Instructions] Our first question comes from the line of Jeff Rulis with D.A. Davidson.
Jeff Rulis
Just a question on the, I guess, the slide, your beta slide. Looks like the total deposit beta at just under 35%. Any thoughts on where that terminal or peak level would be and kind of timing of that as you guys forecast?
Bruce Lee
Yes, I think, I’ll jump in this. Yes, yes. Like you said, so far, we’ve been at about 35%. If you move up to customer deposits, it’s 22%. That’s the one we can really manage, Jeff. So I think we’re doing pretty well there. If you look at what happened this last quarter, it was pretty high at over 105%. So we, in this last cycle or two, have had to really follow the rate increases, at least on a percentage basis, given the competition.
Our belief is and our hope is that now this next raise, and if there is another one, that we can get back to more normally a 30-or-so percent deposit beta for the next raise or two and which would keep us probably in that 25% to 30% range in total cycle for our customer deposits. And that’s about normal for us in the total cycle move. So I think that’s reasonable, but it really depends on competition.
Jeff Rulis
Okay. So you think you kind of bounced along the top side of that and maybe rein it in, in coming quarters. Is that — did I capture that right?
Bryan McKeag
Yes. So slowing down to maybe that 30% beta here in the next move or two or whatever that calculates out to, but that should keep us within our normal beta move for customer deposits.
Jeff Rulis
Okay. Got it. And then just to jump in gears to the charter consolidation. I get a sense for — I think you’ve talked about $20 million annually. What amount of saves have been achieved to date? And maybe I’ll just leave it there. Just what percent have you got to so far?
Bruce Lee
Bryan, do you want to take that one?
Bryan McKeag
Yes, yes. I think I would — it’s hard. Expenses tend to be a little bit, hate to use the term like — there’s a lot of things that go in and out that it’s hard to isolate what’s just related to consolidation as we move forward. Our goal, and I think if we can get the leverage, that if you look at our Slide 14, we were down — I think in the fourth quarter, we were down close to 2.12% or 2.10% on our core cost per asset.
That’s where we’re shooting for. So we’ve got about half to three fourth of it, I think, today. And I think it’s going to come at the end when we can finally get to one bank, and we’re doing things one way across everything. So a little ways to go, but a lot of that is in.
Bruce Lee
So Jeff, I think Bryan was right. I think our number’s between $13 million and $14 million of the $20 million is already in, and we have another $5 million to $6 million to go.
Jeff Rulis
Okay. And that aligns with maybe end of year? I mean you talked about the expectations, or Bryan did, about expenses for the next couple of quarters. Is that kind of the charter costs kind of that stops and fully achieved by year end, is that, generally speaking, the expectation?
Bruce Lee
Yes. All the costs will be done by the end of the year.
Operator
[Operator Instructions] Our next question comes from the line of David Long with Raymond James.
David Long
Bryan, you talked about the assumptions on the NIM going forward maybe low to mid-3.20% range. What type of assumptions do you have baked in there? Is that assuming the Fed futures are accurate and we may be done with the rate hikes? And then from the noninterest-bearing deposits coming down to 28%, what do you — where are you thinking that goes in that 3.20% — low to mid-3.20% outlook?
Bryan McKeag
Yes. I think it’s a fairly flat assumption on the non-maturity deposits. And we might need this — we might need to keep this last move at that 30 data so we can get just a little bit of NIM help. It won’t be a lot, only a basis point or two, but that basis point or two in this environment is a lot.
So we need both this last move to kind of come through a little stronger on the income side than the expense side, and then we need to hold our noninterest-bearing deposits relatively flat. We did a decent job last quarter. If you look at customer deposits, they only went down one percentage point of the mix. So hopefully, we can hold somewhere in that range. Bruce, I don’t know if you have any other comments around — thoughts around that.
Bruce Lee
Yes. So David, when we think about kind of our modeling, it’s being able to fund the loan growth with deposit growth. As we mentioned, we think $150 million to $200 million of loan growth. We think we can grow deposits plus or minus $150 million.
And then the other thing that happens with that is as Bryan referenced, when you include the wholesale funding, it’s 28%. But if you take the wholesale funding out, it’s 34% is demand. And if we’re able to take all of our cash flow off the investment portfolio and pay down the wholesale funding by $250 million, that shift helps us as well.
David Long
Got it. Makes sense. And then separately, more of a bigger picture strategy question, but there’s a lot of disruption in the industry now after the events from March. Within HTLF, how much time would you say is spent focusing on offense versus defense? And then how does that compare to maybe how much time you were spending on offense versus defense a year ago?
Bruce Lee
Great question, David. I’d say right now, we’re probably 60% on offense. And I’d say a year ago, we were probably 80%. So we’re still spending a lot of time on offense, and part of that is just outreach to our existing customers and the prospects. We’re spending almost all of our time doing that. And when you think about offensive, I would also include recruiting. We’re very active in the market recruiting talent as well.
Operator
[Operator Instructions] Our next question comes from the line of Andrew Liesch with Piper Sandler.
Andrew Liesch
Just wanted to follow up on the margin here. Some of this margin stability also benefit from the earning asset mix if you’re reducing securities book by another $250 million, and that helps reduce some of the funding side, so just maybe better earning estimates. Is that also helping the margin there?
Bryan McKeag
Yes, that’s part of it, yes.
Andrew Liesch
Do you think that’s probably…
Bruce Lee
Go ahead, Andrew.
Andrew Liesch
I was just going to say that it seems like if you’re going to take out the $250 million for the next few quarters, that trend should remain consistent for the — at least in the next year. And then if you have that plus an eventual stop in the Fed raising rates, I mean, where do you think the margin ultimately bottoms out? When do you think it can start rising again?
Bryan McKeag
That’s a good question. Again, if we can pull off what we think, we’re going to be trading out deposits at, on an average, should be probably today in, what, the mid-3s. If it’s all CDs, it will be a little bit higher, but if we can get a blend and hold our deposits, and that will fund loans that are now in the upper 7s to 8%. And then if we can take the investments and use that to pay down, you’re taking probably 4% and paying down 5% costing deposits.
So all of that is positive to the NIM, so — but to me, it’s all about the deposit side. Can we hold the deposits? And can we hold the betas that we need to? So that whole kind of moving parts can happen. If that doesn’t happen, you’ll see the margin probably continue to slide a bit. How low could it go if that happens? I would say, without doing a lot of math, I think could be a little bit. Five basis points, 10 basis points, more but that’s a lot of moving parts. So Bruce, I don’t know if there’s anything else that comes to mind on this question.
Bruce Lee
Yes, Andrew, for us, it’s all about doing what we did this quarter in opening up all those net new accounts, over 3,400 on a combined basis and continue to grow the new relationships and being able to fund the loans with deposits. We’re able to do that, we’re able to actually grow our margin. I mean, that’s the entire strategy that we have. That’s why we’re playing so much offense. That’s why we were spending the advertising dollars, and we’re definitely seeing the account growth.
Andrew Liesch
Got it. Just on the fee income side, just the increase of the service charges. The new customer accounts contribute to the uptick there?
Bryan McKeag
I would say probably not a lot yet, but they will, especially on the commercial side. The uptick in the service charges is where, as Bruce mentioned, the Visa, we had a onetime Visa kind of bump.
Bruce Lee
But they still grew EBIT excluding that almost $1 million. So there’s a lot of good momentum in our service charge business, Andrew.
Operator
[Operator Instructions] Our next question comes from the line of Terry McEvoy with Stephens.
Terence McEvoy
Maybe for my first question, I looked at the annual meeting presentation, and you talked about recruiting and hiring in markets. I guess the question is, how has the market disruption from March assisted you or maybe worked against you on the hiring front? And then last week, when I think about that bank merger that was announced, there’s a lot of overlap with your markets. And could that present an opportunity for you?
Bruce Lee
Yes. So Terry, I’ll take that one. So the comments both in — at the annual meeting as well as what’s been going on since the annual meeting, Denver is clearly one of the markets we’ve been very successful in, in recruiting, also in Arizona and a couple of others. So we’re on that path, and we clearly think that the disruption on the acquisition will help push some of the people over the edge. There was a lot of loyalty to the one bank where we have a lot of overlap. And I think now, just in the last week, we’ve seen some activity there.
Terence McEvoy
And then a question for Nathan. What are you monitoring and looking at within the C&I portfolio? Any areas you’re deemphasizing and some red flags, yellow flags?
Nathan Jones
Yes. We feel pretty good about our C&I portfolio especially. It really continues to perform. We’ve had a couple of one-offs we continue to launch, but really, if we’re just looking at the industry there, I’d say probably focusing on the ones that might be most acceptable to a potential downturn. So contractors, construction-based firms and other type service providers are probably getting the most focus now.
Operator
[Operator Instructions] Our next question comes from the line of Damon DelMonte with KBW.
Damon DelMonte
So just to kind of follow up on the credit topic, just wondering what your maturity schedule looks like for commercial real estate loans over the next few quarters. Do you have a lot coming up for renewal?
Nathan Jones
No, not really. It’s one of the real positives for us. We really do have a very elongated maturity schedule. I think we even have that highlight in our Investor Day, which you can see there. But I’d say about 50% of our portfolio from the CRE, general CRE portfolio, is going to mature over the next 1.5 years. So very little. The vast majority of it is in out years, much further out, around the four to five range.
Damon DelMonte
Got it. Okay. That’s helpful. And then, Bryan, with regard to the expense guide, should we anticipate the advertising expense staying elevated like we saw this quarter? Or does that kind of come back in during the next couple of quarters?
Bryan McKeag
Probably going to stay about where it was, maybe a little bit lower, but I’d say about where it is.
Bruce Lee
Damon, this is Bruce. I would say probably for the third quarter, it will remain where it is. We’ll probably begin to reduce a little bit in the fourth quarter. At least that’s been our history.
Damon DelMonte
Got it. Okay. And then should we also think about the outside services line item coming down as well because of some kind of onetime things that occurred this last quarter?
Bryan McKeag
Yes. That’s what we need to focus. That’s one of the discretionary items that we get in. There’s lots of pieces in there, so it takes a lot of different areas, but that’s where I think we need to focus. We’ll — $0.5 million or so out of there, if not more.
Operator
As there are no further questions at this time, I would like to turn the call back to Mr. Lee for closing comments.
Bruce Lee
Thank you, Abigail. In closing, HTLF had a solid second quarter. We endured industry challenges and stayed focused on our commitment to serving our customers, communities and each other. We continue to add commercial, small business and consumer customers, grow loans, increase fee revenue, improve customer service, maintain stable credit quality. We’re driving growth, and we’re well positioned. We have momentum. Thank you for joining us. Our next quarterly earnings call will be in late October. Have a good evening.
Operator
Thank you for your participation in today’s conference. This does conclude the program. You may now disconnect.
