Heartland Financial USA, Inc.
Q4 2007 Earnings Call Transcript

Published: 29 Jan 2008

[Operator:]

Welcome to the Heartland Financial USA fourth quarter 2007 conference call. (Operator Instructions). This conference is being recorded today, Monday, January 28, 2008. I would now like to turn the conference over to Leslie Loyet, Financial Relations Board. Please go ahead ma'am.

[Leslie Loyet:]

Thank you. Good afternoon, everyone. Thank you for joining us for Heartland Financial USA's conference call to discuss fourth quarter and year-end 2007 results. This morning, we distributed a copy of the press release; I am hopeful you've all had a chance to review the results. If there is anyone online who did not receive a copy, you may access it at Heartland's website at www.htlf.com, or you may call Han Hoi at 312-640-6688 and she will send you a copy immediately. With us today from management are Lynn B. Fuller, President and Chief Executive Officer, and John K. Schmidt, Chief Operating Officer and Chief Financial Officer. Management will provide a brief summary of the quarter, and then open the call up to your questions. Before we begin the presentation, I would like to remind everyone that some of the information that management will be providing today falls under the guidelines of forward-looking statements as defined by the Securities and Exchange Commission. As part of these guidelines, I must point out that any statements made during this presentation regarding the company's hopes, beliefs, expectations or 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 can be obtained on the company's website or the SEC's website. At this time, I would like to turn the call over to Lynn Fuller. Please go ahead.

[Lynn B. Fuller:]

Thank you, Leslie, and good afternoon, everyone. I appreciate everybody joining us today to review Heartland's performance for 2007. I hope you all had an opportunity to review Heartland's earnings release that was issued this morning. For the next few minutes, I will discuss highlights of our performance and the ongoing implementation of our growth strategy. I am joined today by John Schmidt. John's our Chief Operating Officer and CFO, as well as Ken Erickson our Executive Vice President and Chief Credit Officer. Both will provide additional details on Heartland's financial results for the year, as well as the fourth quarter. In today's earnings release Heartland reported an increase in net income for 2007 to $25.6 million or 2.1% over the previous year. Total assets ended the year at $3.26 billion and just short of $3.3 billion if you add back the assets from the sale of the Broadus, Montana branch. Diluted earnings per share for 2007 were $1.54 compared to $1.50 last year and $0.41 for the fourth quarter. Diluted earnings from continuing operations for 2007 were $1.44 compared to $1.45 last year. Well, since I know all of you are more interested in learning about where we are going and where we have been, I think there is more good news to report today than bad. That being said let me begin by addressing non-performing loans, which certainly had our full attention during the second half of 2007 and it's our number one priority for 2008. Today we've moved out and collected out a number of problem credits and have been aggressively downgrading others. As a result our non-performing loans remain in the $30 million range, which is much higher than our historic levels. For the year our provision expense was $10 million, net charge-offs were $7 million and reserves reached 1.45% of total loans and leases at year-end. In the fourth quarter of 2007, we hired a seasoned workout specialist as Vice President of Special Assets. This individual is charged with the responsibility of working with our member banks to substantially reduce non-performing loans from the current levels to compare more favorably with our historic levels. We believe we can unlock sizable earnings potential in 2008 to do the successful achievements of this goal though we are navigating in turbulent times several areas of our performance truly standout as positive. For 2007 our number one priority was margin maintenance and I was very pleased with our efforts in this area. For the fourth quarter we maintained our net interest margin at 3.87% equal to the third quarter of 2007. For the year we fared much better than many of our peers averaging 3.95%. Though we will be challenged to maintain this level going forward, we are proactively managing our pricing in concert with the decline in market rates. Second we continue to show pretty good growth given intense competition and the current economic environment. Total loans increased to $2.43 billion and deposits increased $2.4 billion. Profitable growth is the key to ramping up the contribution from our new branch investments and we continue to channel resources towards increasing same store sales year-over-year. Our benchmark for de novo offices is $10 million in net new deposits each year. For the year ahead we are anticipating loan growth to be similar to the growth we experienced in 2007. We are expecting our de novo banks in both Denver and Minneapolis to make meaningful contributions to this year's goal. The third area where we are particularly pleased is in noninterest income. For the year this grew by $2.5 million or 9% over 2006. We saw our Wealth Management Group revenue increase by 11% and brokerage revenue increased by 66%; in part due to the purchase of a book of business in the Denver market. Additionally with respect to noninterest income, $1 million came from a one time gain on sale of our credit card portfolio during the fourth quarter. We now have a much improved and competitive credit card product to offer our customers and given where we are in the credit cycle our timing could not have been better. We were also able to retain an income sharing arrangement with the purchaser of the portfolio. I'm sure you also noticed the year-over-year decrease in human resource expenses in the fourth quarter. As the year ended we acknowledge that our performance in 2007 fell short of expectations and behind our plan to double earnings per share and assets every five to seven years. As a result bonus payments at both the corporate member bank level were reduced based on performance and additionally the 2007 profit sharing contributions were adjusted downwards to bring them also in line with the company's performance. In terms of expansion, 2007 was a very active year in which we opened five new branch offices, relocated one office and initiated the organization of our newest de novo bank charter, Minnesota Bank & Trust. Looking forward, we view our de novo expansion as a cost effective way to plant the seeds for future earning power. In 2008, we anticipate opening four new branch offices with new locations planned for Albuquerque, Mexico; Mesa, Arizona and one new office in addition to the main location in Edina, Minnesota. Our application for the Minnesota charter has been filed and all approvals are expected within the next few weeks. Our President, Kate Talley is assembling an outstanding team of experienced bankers from the twin cities, which are eager to get rolling with Heartland's tenth charter. We anticipate our grand opening in the second quarter of this year. Continuing our forward look into 2008, we've identified six top corporate objectives for the year and these are, number one, and most important achieving a substantial reduction in non-performing loans. Number two is generation of core non kind deposits. Number three is overhead reduction with the goal of trending another 5% out of our current 2008 budget. Number four is maintenance of our net interest margin near its current level. Five is continued emphasis on training especially in the areas of sales and supervisory training. And lastly number six is disciplined and accountable leadership to stay on-track with our plan and budget. In closing I still believe we have a short at our stated strategic goal of doubling EPS and assets every five to seven years, which will end 12/31/2010. We realize this is an aggressive goal and factors beyond our control such as the economy will have an impact on our future success. Well, that concludes my comments, I will now turn the call over to John Schmidt for more details on our fourth quarter and full year financial year results and then John will introduce Ken Ericson who will provide an additional commentary on the credit side. John?

[John K. Schmidt:]

Thanks Lynn and good afternoon. It's my pleasure to provide additional details on this morning's press release. Consistent with previous calls I'll put my comments on the most substantial changes to our balance sheet and income statement in the past quarter 12/31/07 versus 9/30/07. From a macro perspective, at this juncture I would suggest that Heartland has weathered the storm fairly well in terms of earnings and limiting the increases of non-performing loans. Looking first at the balance sheet, total loans increased by $2.5 million in the fourth quarter. This quarter's performance was negatively impacted by efforts to clean up our loan portfolio. Representative of that, we successfully moved $24 million in sub-rated credit out of our banks in the fourth quarter. The majority of these credits were still on accrual. Finally in the fourth quarter, we closed on the sale of our credit card portfolio, which had $6 million in outstandings at the time of sale. Even considering these sales, loan productions for the year totaled $94.6 million. From the sale of the credit card portfolio and those loans for the Broadus, Montana location are included, totaled loan would be $121.5 million. Looking ahead to 2008, we would forecast loan production to be in the $125 million to $150 million range. Net charge-offs for the quarter totaled $1.7 million and $6.9 million from a year-to-date perspective. Net charge-offs for the fourth quarter expressed as a percentage of average loans and leases sold 8 basis points. Citizen's Finance, our finance subsidiary, represented approximately 40% of this total. Finally, while our allowance for loan on lease loss methodology remains consistent, we continue to explore ways to refine the process including the purchase of software which should be fully operational by the third quarter of 2008. At the conclusion of my remarks Ken Erickson, our Chief Credit Officer will provide additional detail on our loan portfolio. Core deposits, meaning, excluding broker deposits increased by $2.1 million from a quarter-over-quarter perspective. We continue to see significant competition for deposits and recently have borrowed alternative fund resources to be more effective from a rate perspective. Core deposit growth for the year totaled $96 million or 4.35% and $126 million or 5.72% for those deposits still with our branch in Broadus Montana are considered. As Lynn mentioned net income totaled $0.41 for basic and diluted shares. Fourth quarter results were positively impacted by the previously mentioned free credit card portfolio which reflected a $1 million net gain. Lynn also mentioned that we were able to maintain our net interest margin at 3.87% for the quarter. By and large we are able to accomplish this by aggressively moving funding rates down consistent with the Federal Reserve cuts. Going forward with the opportunity to reprice 77% of our CD portfolio in the next year at rates at least 50 basis points lower than the current 4.87% rate, we see a continued relative stabilization of the margin in 2008. However, given the asset-sensitive nature of the balance sheet, the margin remains exposed to additional Fed rate cuts. The scalability of the margin is also a function of our ability to grow loans. While non-interest income reflected an increase in the fourth quarter compared to the third most of this is attributable to a $1 million gain from the sale of the credit card portfolio. Balance in net was the amortization of the investments made in limited liability companies which served to reduce the other non-interest income line item by $838,000. The offsets of this charge are reflected in a lower tax expense for the quarter. Other areas of significant improvement include loan servicing income in addition to brokerage revenue. Going forward I would anticipate that we'll able to increase non-interest income at a level at least consistent with the current year's growth of 8.5%. Besides from the provision the most obvious issue impacting our financial savings in the fourth quarter was reduction in the non-interest expense. Included in this total is dollars in the employee benefits line item which decreased by $2.4 million or 17% for the third quarter total. This reduction was due in a large part to reduced incentive compensation and profit sharing payouts as it has been evident that we would not hit our performance targets for 2007. Additionally relative to profit sharing the decision and the level of contribution is made at our December meetings as such the entire reduction poured in the fourth quarter. For modeling purposes given the majority of our salary increase is going to affect in January, I would suggest that the third quarter run rate of plus 6% will provide a reasonable base line. We are again pleased to see a relative stabilization of the remaining categories in the non-interest expense area. Looking forward to 2008 we anticipate at least a 10% increase in our paid services primarily associated with FDIC insurance costs. This increase is driven in part by the fact that our credit is nearly fully utilized at our largest bank. Finally the tax rate for the quarter was 22.9% reflected in recognition of tax credits associated with Dubuque Bank and Trust ownership in two limited liability companies, and non-certified historic structures. For 2008 our regional expense will be in the 30% range. This concludes my remarks. I would now like to introduce Ken Erickson, Heartland's Executive Vice President and Chief Credit Officer. Ken is a CPA and has been in the banking industry for the past 32 years, all at Heartland. Given where we are in the credit cycle, we thought it would helpful to bring Ken's expertise and perspective into this conference call. Ken

[Ken Erickson:]

Thank you, John. Good afternoon. As John said I'm Ken Erickson, Executive Vice President and Chief Credit Officer for Heartland. I do appreciate this opportunity to speak today regarding Heartland's home portfolio. This past year was certainly atypical when you compare the 2007 results to prior years. I will not speak to the specifics behind individual credit losses, but in my opinion they are not reflective of a new level of expected losses of the company. Underwriting remains strong and collections efforts appropriate for each individual credit. Only five non-performing credits exceeded $1 million as of December 31st. These five credits totaled $16.7 million. Two of these represent 39% or $12.3 million of the total non-performing loans as of December 31st. As mentioned in the past, we have several loans with government guarantees. $2.5 million of our non-performing loans represents the guaranteed portion of those loans. Uncertainty still exists regarding a few larger credits in our portfolios. Material losses were not foreseen in any one of those credits, but the timing to resolve the issues are uncertain depending on whether we can return the loans to a performance status or legal actions will become necessary. Most of our markets appear to be relatively strong with minimal declines in real estate collateral values. The exception to this would be the Phoenix market where we have seen a greater decline in real estate value. Although 76% of our loan portfolios are secured by real estate, the risk in theses portfolios is most likely less than that number may suggest. It has been the practice of this organization to seek out complete customer relationships versus financing individual transactions or purchasing loans through brokers or other participating banks. This has led to the majority of our loans being within the primary trade areas of our member banks, as well as to a high percentage of our commercial real estate loans being owner occupied. Whenever possible, we also structure our loan, so that they are cross collateralized. Our goal in 2008 is to significantly reduce the net losses, from the levels seen in 2007. Citizen's finance company, our consumer finance subsidiary has $40 million in net loans as of December 31st. An increase of 11% in 2007, their primary business is to provide secured closed end credit to customers that represent a higher credit risks and loans known within the bank consumer portfolio. Most of this credit is secured with personnel vehicles. Although they represent only 1.2% of the assets of Heartland, they do have a significant impact on certain numbers within the consolidated financial statements. Citizen yield on loan was 21.3% in 2007, an appropriate yield to offset their net losses of 4.3%. Their losses of $1.7 million translates into 7 basis points of net loan losses, while the bank contributed the remaining 23 basis points, towards the 30 basis points shown in the consolidated financials of Heartland. I do not anticipate significantly different performances within this entity in 2008. Consumer loans represent 7% of the overall bank portfolio with home equity lines of credit representing approximately half of that amount. A potential softening in consumer spending should not have any significant impact on our overall credit quality. As John commented, we have been busy implementing a new software system acquired from [Immatrix]. With this system we will transform to a dual risk rating system and have the opportunity to perform stress testing and migration analysis on various portfolios of segments. It should be fully operational in the third quarter of 2008. This is a significant tool to our risk management program and will assist us in fine tuning our allowance methodology. With that, I will return the call back to Lynn.

[Lynn B. Fuller:]

Thank you, Ken. And at this time, Leslie I think we can open up the call for questions. (Operator Instructions). Our first question comes from the line of George Richman with Richman Corporate Services. Please go ahead.

[George Richmond:]

Thank you. You people have had a lot of experience in starting new banks and I think they will help you. You now have one in Denver and second on the way in Minneapolis. Can you give some guidelines for this year as to how much of your time on the top level will be devoted to these entities? And then, how do you see the progress by quarter turning red ink to black ink as these banks get up and running?

[John Schmidt:]

Guys maybe I can start out on that George and just say that the new de novo's do take a bit more of our attention in the first year. Once the local President and the Board have pulled together their management team, they become pretty self sufficient, but then any acquisition or de novo start up is a period of time of adjustment where they are getting accustomed to our culture and our way of doing business. Typically the banks will lose a $1 million in the first year. We like to see that second year drop down to somewhere in the $0.5 million to $0.750 million. But that will depend on how quickly we expand their branching network. We have had a philosophy of find a anchor, a group of branches strategically off main arterials in these big markets close to magnets. Magnets, being either grocery stores or shopping centers where we have good locations that are easy to access and right off major thoroughfares, especially where we see heavy concentrations of small medium sized businesses and a lack saturation of competing banks. In the third year, we'd like to see the banks to be profitable and fourth and fifth year more so. I can't tell you that that’s always happened but it has happened to with some of our banks.

[George Richmond:]

Okay, that's great -- because what that tells me is that you will be pricing somewhat higher cost this year from the new banks’ openings, but '09 and '10 should be really very good years for you, then?

[John Schmidt:]

That would be our hope, George. The only thing that I would caution is that we have been very active in de novo start-ups because the acquisition price for banks that we would be interested in -- and those markets that we are interested in expanding -- have been very pricey. We've seen multiples of up to three times, and we've seen multiples of earnings up to 28 times. And quite honestly, at those levels we have never been able to make sense out of them and ensure that they would be accretive to our earnings. Our M&A strategy continues to be focused on growth markets, where we have already established a presence. In parts of those markets, we can better consolidate current operations and get more economies of scale. If we venture into a new market paying those historic multiples just has never made sense to us. So we have done pretty cautious acquisitions. We are still looking to acquire, but we would have to see the pricing at a level where it could be accretive to earnings.

[Kenneth Erickson:]

Well I think your point is excellent though too George and the fact that it does impact your target earnings on the front end, but certainly going forward -- you eluded to 9 and 10, where you would start to reap the benefits and we don’t have the goodwill that we would otherwise have if we did an acquisition. So, there needs to be some patience I think exhibited. But long-term it really does serve the shareholder better in never mind.

[George Richmond:]

Very good. Thank you.

[Operator:]

Thank you. (Operator Instructions.) One moment, please, for the next question. Our next question comes from the line of John Rowan with Sidoti & Company. Please go ahead.

[John Rowan:]

Good afternoon.

[Lynn Fuller:]

Hi, John.

[John Schmidt:]

Hi John.

[John Rowan:]

Hi, guys. Can you just go over on the margin again? It seems like you are saying that maintenance of the margins is going to be your priority but that there could be some pressure in the near term. I guess -- just a kind of guess of where I think it will fill out later his year -- can you just go over how much reliability there is to repricing again?

[John Schmidt:]

I guess the biggest issue or option we have, Jonathan, is that 77% of our CD portfolios don’t return the next year. If we look at it, we should be able to drop the rate on that portion of our CD portfolio by at least 50 there. We have been able to drive down our savings rate pretty effectively. We feel there's some additional room there at the other end. To reiterate my broader comment, we look at the margin that we should be able to sustain our margins near that 387. Again, it becomes a function of how fast that the Fed does coverage. Our counter balance still remains the CD portfolio -- and to quite a lesser extent, our savings portfolio -- but there's still some room there.

[John Rowan:]

And when do you get into a compression issue in terms of the Fed cutting rates, and you can't lower your funding costs any further?

[Ken Erickson:]

There's a portion of our savings portfolio right now that has effectively hit a floor. Let's say that 20% of our savings total is the balance of that, though. Remember that we had been effective in putting floors into our commercial loans. I don’t have that figure on the top of my head, but call it 30% of our loans, creditable rate commercial loans. We are going to have floors on them. So that starts to counteract some of those decreases at the same time. Again, there is going to be some compression potential, but I think we still depend on a lot of lower rates. I mean, if there is another 100 basis points out there, we are going to see more compression than where we are at right now.

[Lynn Fuller:]

I would just add that we're using this as an opportunity to lock in very affordable financing rates. We put caps on some of our floating rate [cups], so I think this is an area of opportunity as much as an area of risk. But certainly we're totally immune to compression if interest rates drop another 150 or 200 basis points.

[John Rowan:]

Okay. Thank you. That was it.

[John Schmidt:]

John, one last point, too. We have been very affected at the same time by recording prepayment values in our fixed-rate loan. So, again, we try to balance a lot of this liability exposure on the asset side. It's something that we've been very cognizant of throughout this rate cycle.

[John Rowan:]

Actually, one more question

[John Schmidt:]

Correct.

[John Rowan:]

Okay. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Jon Arfstrom with RBC Capital Markets. Please go ahead.

[Jon Arfstrom:]

Thanks. Good afternoon, guys.

[Lynn B. Fuller:]

Hey, Jon.

[Jon Arfstrom:]

Hey. Lynn, can you talk a little bit more about the expense management initiative, kind of where and what you're thinking about there?

[Lynn Fuller:]

Well, as we go through our budgeting process every year, we are very strict on the expense side because we know we've got quite bit of expense coming out of these de novo initiatives and our branch expansions. But those expansions do provide profits to us in future years, without adding a lot of goodwill. We went through our budget process, and we felt we did a good job. But we think there is an opportunity, and we've gone back to our bank presidents and to our holding company. We think there is an opportunity to gain another 5% expense reduction out. So we're turning over every rock we can to address that end of the income statement. As you know, it gets very challenging to grow top-line through '08,and we have got to get it out of the expense side. So that has been an initiative that's been put in play right after we finished the budget in December, and our member banks and the holding company are coming back with your ideas on the specific dollars and where they are going to get them. Also, we have started on a project at the beginning of ’07 called Six Sigma Workplace Lean, and we have a number of initiatives under Workplace Lean that we are looking at our processes to see if there is a way that we could improve those and become more efficient. We look at productivity and at all of the production levels of our salespeople, both in the retail and the commercial platform. Where we don't see the levels of productivity that we expect, we move people out and get somebody in that can give us the productivity. So, we are looking at all levels, Jon.

[Jon Arfstrom:]

Okay. Couple more questions. Maybe John, for you, the loan loss provision for the quarter is a little higher than we had anticipated, and not terribly higher. But I guess when you think about your loan growth numbers and you are also giving us some comforts on asset quality. I guess the question is

[John Schmidt:]

Let me just say that we certainly hope so. At this juncture, though, we think that we have been very consistent on the use of our formula, Jon, and we need to be. So some of it is certainly driven by the losses, some of it is driven by the growth, and some is just being sure we maintain some consistency with the formula that we've given over the years. So when Ken spoke to the new methodology that ultimately provides relief, it is yet to be seen. But we certainly would hope for that, iven everything we are seeing as far as the credit culture and credit environment we are working in right now. Going forward, if we can clean up some of these non-performing installments, certainly hopefully we're going to see some reduction in the overall amount of loans.

[Lynn Fuller:]

I might add one thing, Jon

[Jon Arfstrom:]

Okay. Good. Just one question on loan growth. I appreciate the number that you gave us for your expectations for '08. But I am just curious how the near term pipeline looks? How should we think about this? When the Minnesota Bank is open, we might see a bit of an acceleration in growth? Or does the near term pipeline look pretty strong?

[John Schmidt:]

Let's say, based on what we are seeing right now, our pipeline right now is about 70% of what we saw in 2007. So we are on the same page, if you will, Jon. We had a strong first quarter from last year, but even then, at 70%, it was a strong quarter. I think it's fairly representative of what we do.

[Lynn Fuller:]

Yes, and the pipeline right now doesn't include a whole lot for Minnesota Bank & Trust. We really need to see Denver and Minnesota step up and make a fair contribution. If that happens, then that will make up for what we think might be a bit slower production in our more mature banks.

[Jon Arfstrom:]

Okay. Great, thank you.

[Ken Erickson:]

Thank you. And expanding on the big two is that we are the strong providers, and we would still like to be as being a very capable production bank this year.

[Jon Arfstrom:]

Okay. Alright. Thanks.

[Operator:]

Thank you. Our next question comes from the line of Brian Martin with Howe Barnes. Please go ahead.

[Brian Martin:]

Hi, guys.

[Lynn Fuller:]

Hi, Brian.

[John Schmidt:]

Hi, Brian.

[Brian Martin:]

Just may be a question for Ken, but in terms the non-performings, the quarter was pretty stable. I guess they were up a little bit. I’m just wondering if you could talk a little bit about how you talked about aggressively downgrading some credits, and I know John, you talked about moving some out there, were still an accrual. Can you just talk about, I mean, that numbers was relatively flat, Could you just talk a little bit about the migration, or maybe what was coming in or what was going out? Or was it kind of plan, as it looked? Or were there any large movements that you can talk a little bit about?

[Lynn Fuller:]

Sure, Brian, thanks. There was movement in there. Unfortunately, some moved in and replaced the dollars and that did move out. We had a couple of properties that were in our Heartland business banks that we were able to resolve. We had a $1.5-million loan that we did fully pay out. We had another $1 million non-accrual loan that came back to a performing status. In one of our banks, we had a loan just slightly under $1 million that's done some spec buildings, well-collateralized, but it did fall past 90 days and came off accrual. In our Arizona market, we had an aggregate of about four or five credits that brought up a couple of million dollars of non-performing on some various residential real estate lots, spec loans in that market that has created some additional non-performing. So we did see some come out there, but unfortunately the same numbers of dollars, or close to it, came in.

[Brian Martin:]

I guess you're just talking about your goals for the resolution. You seem pretty optimistic as far as getting some resolution here in '08 on some of these that came aboard. Could you give any thoughts, as far as what expectations appear realistic at this point, given what you looked at and whatever call you can offer there as price rectification?

[Ken Erickson:]

First, I would probably say that the goals that both Lynn and I have discussed internally is we feel that that we need to return strong desire return to approximately 3

[Lynn Fuller:]

Brian, I think I mentioned in our earnings release last quarter that I had asked the credit review to be very aggressive in downgrading loans so that we get these credits in front of us and so we can address them and try to resolve them early. I'm not sure that all of our peers areas are as aggressive in this areas. We are. We believe that the quicker that we can get these in front of us and bring in to a head, the lower our losses are going to be. And historically we have done a pretty darn good job of taking collaterals. So I'm pretty hopeful that as I mentioned in my comments, we'll see some real improvements in that area in '08.

[Brian Martin:]

Again, Lynn, you talked about the 24. They came out this quarter and were mostly still accruing. When you talk about your loan growths for '08. And, I guess, what do you act -- I mean you guys feel like you have looked at the portfolio closely enough at this point, that you don’t expect any type of movement? a long life. This is what we saw this quarter moving out -- maybe we are still expecting to see quite a bit of moving out if you got most of that you feel at this point?

[John Schmidt:]

Well. I think it depends on how bad the economy gets. I mean, if we fall into a deep recession, we are not as immune as a banking company. We are not immune to problems that a recession would cause. But at least at this point in time, I think we feel pretty comfortable. We've identified most things. We had credits that were still performing credits with which we were a bit uneasy -- but we have to move, and there are still a couple of banks out there willing to finance them. So, I think we've been pretty diligent on reviewing the entire portfolio and trying to mitigate the risk to the great to the greatest extent possible.

[Brian Martin:]

Okay. And just lastly, over the past 230 days you have watched this type of credits. Can you just talk a little bit about the 9/30 to 12/30 -- 12/31 change? Has that been pretty stable, or have you seen that number move up?

[Kenneth Erickson:]

John hit on that. We are saying that we brought a significant reduction in that number. In those that I recall, significantly over a $0.5 million on the relationship are sub-standard credits. Those reduced by $15 million to $18 million. And the majority of that came with those two large credits that were still performing credits but were showing some layer. The best resolution of those were to move out of our portfolio. So there was a significant dollar reduction in those categories of sub-rated credits.

[Brian Martin:]

Okay. I appreciate it all, guys. Thanks very much.

[Kenneth Erickson:]

Thanks, Brian.

[Operator:]

Thank you. Our next question comes from the line of Brad Milsaps with Sandler O'Neill. Please go ahead.

[Brad Milsaps:]

Hi, good afternoon.

[Lynn B. Fuller:]

Good afternoon.

[John Schmidt:]

Good afternoon.

[Brad Milsaps:]

Hi, John. I was trying to quickly jot down your comments on some of the income statement items this quarter. I didn’t quite catch some of your color on the other expense category. I guess it is up to about $1 million on a quarter basis. Any additional color there? I apologize if I missed it.

[John Schmidt:]

The other expense category?

[Brad Milsaps:]

Yes, sir.

[John Schmidt:]

I don't know if there is anything real significant that jumps out in that category, Brad. I think there were some telephone charges that went into that line item. Really, it was nothing that would jump out at you as one [single event], because I did look at that, quite honestly, and despite six items that contributed about $700,000. So, a variety of things, but nothing that's substantial. Maybe your question goes to what it is on a go-forward basis. I would rather see it going back a lot more closer to the Q3 level.

[Brad Milsaps:]

Your guidance, the 6% guidance, strictly relates to personnel expense?

[John Schmidt:]

Yeah. That was 6% overall, you’re correct. That was just personnel expense. The big thing, I am sorry, the one thing that I was looking at was outside services, in that outside services line item was the FDIC cost and that is the one that has our attention given the fact that there has obviously an increase in our overall FDIC premiums. And the fact that the credit that we have at Dubuque Bank and Trust Company is running out, so that was my largest concern and the other expense there wasn’t really anything that jump outs. Are you talking about the $4.1 million?

[Brad Milsaps:]

That's correct

[John Schmidt:]

Yeah, there wasn’t anything substantial there. What I was referring to is the outside services which contain the FDIC costs.

[Brad Milsaps:]

Okay.

[John Schmidt:]

Brad, if you look at other outside -- other noninterest expense rather model Q3 level versus that Q4 level.

[Brad Milsaps:]

Okay. And then final question, of course you guys don't have a lot of construction development exposure which seems to be giving everyone the most trouble at this point. But you do have a fair number of loans in that C&D bucket I guess at the Arizona Bank and also in Albuquerque. Can you Lynn, or Ken can you comment a little bit on just kind of the health of those markets as you view them at this point? Thanks.

[Ken Erickson:]

I will comment first. Arizona certainly has a strong [pack] in the values that we’ve seen in real-estate and the turn time on some of the projects down there. It's certainly going to extend the absorption time for some of the land development plans that are underway down there. Fortunately the market is still growing at such a rapid pace, that its growing down may go from 6 months to 9 months of absorption period in some of the areas. Now we certainly do see that there is a lengthening of time of absorption when you get farther away from the core populous area. So we have seen some of the development projects in the market that are significantly a distance from the main Phoenix metropolitan area are slowing down significantly, and Lynn I asked you if you wished to go further with that comment.

[Lynn B. Fuller:]

We have a little bit of that type of business in Madison, Wisconsin, a little bit in Phoenix, little bit in Bozeman, Montana and Billings and as well in Albuquerque and I had have to say I am just amazed that how well the Albuquerque market has held up. That we consciously have been pulling back a bit from that end of our business in Albuquerque, but we just don't see a real slowing down. It's certainly not at its absolute peak, but I think builders down there have been quite cautious. They have known that things are going to slow a bit, and they have invested real well. In Montana, still incredibly big growth in Billings and Bozeman in those growth markets. I think in the case of Bozeman, I think some of that land development got a little ahead of itself. So as Ken suggested, give it a little more time for absorption of that inventory. Madison has had a little bit of a pullback, but that market over the years has been so stable through any recession that I think you have definitely seen a slowing in Madison that's constant that's not anywhere near what we see in Phoenix. Phoenix clearly is the market that we are in that has seen the greatest adjustment and it's in the outlying suburbs. One exception that might be Casa Grande, because it's right on highway 10 en route down the Tucson. But some of the more westerly suburbs that were later to develop and they are farther out. Fortunately, we haven't had any investment in those markets, but they had really some slowdown.

[Operator:]

Thank you. (Operator Instructions). There are no further questions in the queue. And I will turn it back over to Mr. Fuller.

[Lynn B. Fuller:]

Thank you. In summary, I would just say that Heartlands financial performance remains solid with continued EPS growth, certainly reasonable balance sheet growth, solid non-interest income growth and a a leveling of our noninterest expense and I would expect that to continue through this year. I would like to thank everyone for joining us today, and hope that you can join us again for our next quarterly conference call that's scheduled for April 28. So wish everybody a nice evening. Thank you again.

[Operator:]

Thank you. Ladies and gentlemen, that does conclude our conference for today. Thank you for your participation. You may now disconnect.