Satsuma Pharmaceuticals, Inc.
Q4 2007 Earnings Call Transcript

Published: 4 Feb 2008

[Operator:]

Good day, everyone, and welcome to the Fourth Quarter and Fiscal Year 2007 Earnings Conference Call. Each of you will be on listen-only mode until the question-and-answer session following today’s presentation. Today’s conference is being recorded for replay. Additionally, the replay will be available at Sterling’s website, www.sterlingfinancialcorporation-spokane.com, immediately following the call. I would now like to turn the call over to Mr. Harold Gilkey, CEO and Chairman of Sterling Financial Corporation.

[Harold B. Gilkey:]

Thank you very much, Kim. To begin today’s meeting, I would like Shawna Manion to read our forward-looking statement.

[Shawna Manion:]

Thanks Harold. Good morning and welcome to Sterling Financial Corporation fourth quarter earnings call. With us today I have Mr. Harold Gilkey, Chairman and Chief Executive Officer and Mr. Dan Byrne, Executive Vice President and Chief Financial Officer. Before I turn the call over to Harold, I must remind you that during today’s, call Sterling’s management will be referencing forward-looking statements that are not historical facts and pertain to our future operating results. These future-looking statements include but are not limited to statements about our plans, objectives, expectations and intentions and other statements contained in this reports that are not historical facts. These forward-looking statements are inherently subject to significant business, economic and competitive uncertainties, many of which are beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Sterling’s actual results may differ materially from the results discussed in these forward-looking statements because of numerous possible risks and uncertainties. These risks include, but are not limited to

[Harold B. Gilkey:]

Thank you, Shawna. We couldn’t have done without that. 2007 was another significant year in the development of our company. Despite challenging economic conditions in some of our markets, we continue to build the Sterling franchise and serve customers in expanded geographic territory. We increase our net income to $93.3 million, a 26% increase over 2006. We increased our total asset by 24% to just over $12 billion. Loans receivable increased 27% to nearly $9 billion while deposits were up 14% to $7.7 billion, and most importantly, our capital increased 51% or $1.19 billion. All of these are record levels. Additionally, we set a record for loan originations of nearly $5.5 billion. With our growth in assets, Sterling became the second largest regional community bank holding company in the Western United States. We are indeed proud of our accomplishments of 2007. In fact, in February we celebrated 20 years of trading on NASDAQ. We also completed the acquisition of Northern Empire and its subsidiary Sonoma National Bank. This was on the heels of completing the acquisition of FirstBank Northwest near the end of 2006. In the first half of 2007, we successfully integrated the operations of both of these banks, what we call painting them Sterling green. These acquisitions brought significant resources in customers and employees to help us expand our geographic reach of our Hometown Helpful services and products. During the second half of 2007 we were reminded why we always prided ourselves on the strength of our credit management team and our underwriting discipline. While none of us really enjoy going through downside economic cycles, the recent slowdown in some of our residential construction markets has brought out the best in our people, as they have been taking positive proactive measures to protect asset quality, working with our residential construction customers, and of course taking appropriate measures when necessary. Dan will get into more detail on our asset quality, but I would like to tell you that over the past 90 days, we have reviewed our position on every residential loan in our portfolio. We have received updated appraisals or broker’s opinion of value, which of course are more correct. And either our credit administrator or our special assets staff had met with these borrowers and/or have inspected all the projects in Boise and Bend where we are seeing the biggest slowdown in our market area. Our Chief Credit Officer and Head of Special Assets will be visiting California later this week. We are comfortable with the valuations on these properties. The majority of our residential construction borrowers have long-term relationships with our lending officer and our company. So we feel we have a good understanding of their business but we are confident that they are solid bank customers. Additionally, we have a lot of experience in both the credit administration and the special assets group. There has been some turnover of our non-performing portfolio as some of the issues are being resolved, while others have moved into the non-performing status. I would like to further note that Sterling is insulated but is certainly not isolated from the national economy, and the economy of Pacific Northwest has been very resilient. The region remains relatively strong with economic growth expected to continue to exceed that of the nation as a whole. This region’s strength is due to the Pacific Rim trading position; significant employment roles in the industries such as aerospace and technology; and the strong commodity pricing for agriculture and mineral products. Our long-term portfolio outside of the residential construction is performing as expected. The company’s core market in the Puget Sound and Portland area, where 60% of our residential home portfolio resides, also continues to perform well. When you go through an economic cycle, you want the best people around you, and during 2007 we had the privilege of rounding out our management team for the road ahead. As you know, Heidi Stanley was elevated to the Chief Executive Officer of Sterling Savings Bank on January 1. During this past year, Greg Seibly, a banker of 21 years joined our team as Chief Production Officer. Greg has the responsibility of loan and deposit production at Sterling Savings Bank. Additionally, Debbie Meekins, who joined us with the acquisition of Sonoma National Bank and has 35 years experience as a banker, has the responsibility of our branch network system. Responsibility for the commercial banking rests with Carol Mangan, a banker of 28 years, and of course credit administration is the responsibility of Steve Page, our Chief Credit Officer, who was one of the original employees of Sterling and has over 30 years banking experience. Portfolio management rests with the responsibility of Nancy McDaniel who has 22 years of banking experience. Joining them is Ezra Eckhardt as our Chief Administrative Officer and Tom Colosimo as the Chief Financial Officer of Sterling Savings Bank. We are indeed pleased with the depth and seasoning of our management team, which is ready to meet the challenges before them. During 2007 and after 17 years − yes, let me repeat that − after 17 years, we finally got our day in court to argue for the damages incurred as a result of the United States government breach of contract relating to our past acquisitions. After three weeks in the courtroom, we proceeded with an exchange of briefings to the United States Court of Federal Claims and made closing arguments before that court on January 9, 2008. This case is nearing conclusion. We expect a decision in the first half of the year and we expect our litigation cost of 2008 to be substantially lower than the nearly $3 million we spent in 2007. Regardless of the outside influences that impact our business, I still believe banking is a pretty simple business. Take a deposit; make a loan; collect it; charge a fee, and control your expenses. We are about building a franchise that is a leading community bank for the benefit of our shareholders, our customers, our community and our employees. I am confident in our people and of our Hometown Helpful philosophy. At this point, I’d like to turn the call over to Dan Byrne.

[Daniel G. Byrne:]

Thanks, Harold. The supplementary information provided in the press release, I am going to focus on key highlights for the quarter and then provide the opportunity for you to ask specific questions during the Q&A session. Yesterday, we announced earning of $16.9 million or $0.33 on a per diluted share basis. The increase in earnings from our guidance given in October 2007 for the fourth quarter was due to several items

[Harold B. Gilkey:]

Thank you, Dan. The Pacific Northwest region remains relatively a stable economy. While we have been insulated from the national economy by the growth of companies like Boeing and Microsoft, we are not isolated from the housing related issues that have disrupted the housing finance programs. We do anticipate slower growth in 2008, but we believe there is still considerable momentum in the region. Based on this outlook, we are comfortable with our ability to respond to the economy given that our headquarters and the majority of our business is in the Pacific Northwest. We believe we have a strong management team that has the experience to address the current market disruption and the asset quality challenges. We have developed a diversified loan portfolio and we still expect good demand in the commercial loans in our market, and have an aggressive plan to obtain the deposits needed to fund those loans. We will, of course, focus on building our commercial banking franchise in Sterling, and our residential and loan business in Golf Savings Bank. As we look back at 2007, there are four important accomplishments for the company. We have expanded our total assets of the franchise and our geographic footprint. We generated net income of $93.3 million and strengthened our capital position. We have installed a quality and experienced management team with demonstrated skills. We have a very strong credit administration process and we have identified our loan problems, and we are confident in our ability to manage our way through this cycle. With that, I’ll turn it back to Kim to begin our question-and-answer session.

[Operator:]

Your first question comes from Brett Rabatin - FTN Midwest.

[Brett Rabatin:]

I wanted to ask you a few questions. I’ve actually got a ton, but I’ll just ask you a few here. First, I want to make sure I was clear

[Daniel G. Byrne:]

That’s in provisioning.

[Brett Rabatin:]

And, Dan, can you walk us through the California exposure; how much of that is residential? And then how much in total is Southern California, and how much of that is residential? Because I thought I understood that most of the California exposure was commercial from the Sonoma acquisition, and so I’m a little surprised to hear this sort of language about South California, so to speak.

[Daniel G. Byrne:]

With respect to the Southern California, we do have loan officers here in Spokane that have had long standing relationships in a prior life with the borrowers in Southern California. But we effectively have two borrowers in the Southern California that are in the nonperforming, and that’s what we identified in the press release and on the conference call.

[Harold B. Gilkey:]

What’s our total commitment to California, Dan?

[Daniel G. Byrne:]

Total commitment to California is about $250 million. On a commitment basis, it would be split about $140 million in Southern California and $105 million in Northern California.

[Harold B. Gilkey:]

And over 50% of that would be commercial real estate?

[Daniel G. Byrne:]

Those were just the residential construction portion of the loan over there.

[Harold B. Gilkey:]

Okay.

[Brett Rabatin:]

The classified assets, obviously were about stable and so you had movement into non-accruals and some replenishment of the classifieds. With the provisioning level that you are assuming in ‘08, I was hoping to get some clarity on what gives you the confidence that the loss content in the NPAs in the classified assets is that restrained? –I’d hate to open Pandora’s box, but can you tell us how much of that classified asset base is special mention versus substandard, or give us some idea of why any potential write-downs on the collateral of these loans that you have might be minimal?

[Daniel G. Byrne:]

First-off Brett, I didn’t understand the first part of your statement.

[Brett Rabatin:]

You’re obviously looking for 25 to 30 basis points of provisioning in ‘08, and so that would assume that net charge-offs also are pretty minimal too, unless you’re going to run down the reserve level, which I will presume is not the case.

[Harold B. Gilkey:]

Brett, let me give you an overview

[Brett Rabatin:]

And I understand that, Harold. I didn’t come out from quite the right angle. Obviously, the selling season is coming up so to speak. I just don’t understand the guidance of 25 to 30 basis points of provisioning. It sounds like you’re pretty optimistic that things will start to really improve pretty quickly in terms of home sales in some of these softer markets?

[Harold B. Gilkey:]

I don’t believe that our optimism is based on what’s happening in the market; our optimism is based on what we know about our individual clients. And then that will lead to them meeting their obligations to manage their portfolios.

[Brett Rabatin:]

Okay. So maybe NPAs could be on a quarter or so longer than you might think, but it sounds like you are fairly confident in the loss potential.

[Harold B. Gilkey:]

Yes, Brett, having been around as long as I have been, the one thing I do know is problem assets come on faster than you want them to and they take longer to get rid of than you have to. So my expectation is that you’ll see some movement of classified assets in the nonperforming, which could mean a small rise in the NPAs. But having looked at each of the workout programs, I feel comfortable that the process will take place in the summer months.

[Daniel G. Byrne:]

I would just like to add that the classified assets total is the broadest measure of problem accounts. It does include all of the nonperformers, and from our classification system, it does not include just special mention type loans and things are always moving around a little bit but we’ve given you our best shot of what we think is going to happen going into the future.

[Brett Rabatin:]

Okay. So specials not in there. Okay. I have taken up enough time, I’ll circle back around.

[Operator:]

And your next question comes from Matthew Clark - KBW.

[Matthew Clark:]

Can you touch on the handful of non-performers here. It looks like, based on the breakdown by geography, you got a few projects here that are probably amongst the largest now in your NPA bucket. I think the highest one before was a lot project that was about $7 million in Boise. Can you just give us a sense for the two, say, in Southern California, and I think there is another two somewhere else in Bend, in terms of what types of projects they are? Specifically, how far along they are? What the appraisals said about the project relative to the equity that you thought you had in the project, and then your ability to rebuild equity with some additional collateral, if that’s realistic or not?

[Harold B. Gilkey:]

Easy question, hard to gather all of that. Let me deal a little bit with the California units. Those are really two; one is a residential land development loan and single-family structured loan. The project is complete. The residential construction is underway with 11 houses been completed. The appraisal as you might imagine has come down. I think it’s near where we think our collateral covers it. As I mentioned in my presentation our Chief Credit Officer, and our special assets people are visiting in Southern California and Northern California later this week and will be seeing this project and meeting the developer. The other project is a pre-development loan for a commercial project. The financing for the commercial project, which we were not doing, has evaporated and the developer’s seeking other financing for that project. We have focused that more on the value of the individual who has got a very nice balance sheet, and our appraisal value has declined but we still believe that it has more value than are outstanding. Additionally, we’re looking for additional side collateral from the borrower. Now, I think that deals with the major processes in California. In Bend, we have a couple of projects that are completed but they are lot loans with a couple of residential constructions on those lots. So there is no additional money that needs to be advanced except on, I think,- one house. And there as you know, Bend is a secondary home function and will depend on revival of the economy. But we feel comfortable where we are there. Boise is just an inventory problem and we have 30 some odd builders, which we’ve dealt with. Probably the most problematic are the ones that we acquired in the acquisition of FirstBank Northwest, but we are dealing with those appropriately.

[Matthew Clark:]

And then in terms of the LIBOR based liabilities that you have, in terms of borrowings relative to the asset side of the balance sheet, can you just give us a sense for the magnitude of those that are tied to LIBOR, again, on the borrowing side relative to your assets?

[Daniel G. Byrne:]

That disparity has been between the assets that re-price at LIBOR versus borrowings is somewhere around $700 to $800 million. More recently that’s actually been on our favor, but obviously it’s been bouncing around.

[Matthew Clark:]

So $700-$800 million more in related borrowings?

[Daniel G. Byrne:]

In liabilities more than assets.

[Matthew Clark:]

And I would assume you didn’t see the benefit of 3-month LIBOR coming down until more recently. So, probably wasn’t reflected in the fourth quarter?

[Daniel G. Byrne:]

That’s correct.

[Operator:]

Your next question comes from Jim Bradshaw - D.A. Davidson.

[Jim Bradshaw:]

Could you give me an idea, Harold, about the fluidity in classified assets; how much new came in the quarter versus things that went out?

[Daniel G. Byrne:]

In the classified assets, we had a number of projects going both ways, but the overall level was probably influenced a little bit by making sure that we picked up the commitments in the classified balances. So the overall balance didn’t really increase that much, but it seemed like it slowed down considerably from the third quarter.

[Jim Bradshaw:]

Okay. And the number that was in the press release from September quarter did not include commitments, but the Q4 number did?

[Daniel G. Byrne:]

Just on a few categories. With respect to the residential construction, it always has included, but I think we had some line of credits that weren’t fully being picked up, we made sure we have at the end of the fourth quarter.

[Jim Bradshaw:]

And then on the margin front Dan, I noticed that deposits down obviously a little bit this quarter, but (flub?) advances are up and other borrowings are up a little bit too. I presume that was a conscious effort given the weirdness of deposit prices. What do you think you are likely to see in Q1 from a wholesale borrowing deposit base; shrink the deposit base again and build borrowings, or are you pretty happy with how that liability side looks right now?

[Harold B. Gilkey:]

See Jim, I think that was driven more by our competitors than by us. The big animals were at prey and so we withdrew from that marketplace for a while and funded with our other lower cost reserve funds. Obviously, core deposits are what we’re about and we’ll move aggressively into that territory, but when the big animals are out you’ve got to watch where you are.

[Jim Bradshaw:]

And then, last for me, just one housekeeping item. Dan, in that non-interest income line, the other expenses looks like a debit balance of $2.4 million; is that the prepayment on the TRUP, is that what’s in there, and then anything else?

[Daniel G. Byrne:]

That’s the primary item that’s in there. We have some other things that net in, including I think, some of our tax credits go into that category. But those were the big items.

[Jim Bradshaw:]

And were the North Valley merger charges, I thought I heard you say $2 million, and I was only expecting that to be $1 million; did I just get it wrong?

[Daniel G. Byrne:]

No, I think, what I meant to say was a $1 million for the North Valley. We had some other expenses; combined it was about $2 million.

[Operator:]

(Operator Instructions.) Your question is from Daniel Cardenas - Howe Barnes.

[Daniel Cardenas:]

Can you talk a little bit about your capital levels, do you feel that they’re adequate at the current times or do some building up here through any capital raises?

[Harold B. Gilkey:]

If you followed my career, you would find that I think we have more capital than necessary. We have substantially increased our capital ratios, particularly our tangible capital ratio, over the last four-five years from about a little north of 2% to a little north of 6%. So we have made it a conscious effort to increase our tangible capital ratio, and during this last year, we made a substantial increase of our overall total capital. We feel that we’re adequately capitalized. The review of our position for reserves, we believe that we’re currently adequately reserved appropriately, but we always have some secondary plans in case we have substantial amounts of assets that are highly liquid. So, we could increase the capital ratio if necessary. We still have a shelf offering, albeit it’s not an attractive way to get capital at this stage, but we have some secondary sources.

[Daniel G. Byrne:]

And Dan, I would just say that we’re committed to maintain well capitalized status for the organization. Harold’s right, I think we’ve got very good sources for capital we need already on our balance sheet. So, I don’t think we need to be looking at other forms of raising capital, but we’ll remain opportunistic if opportunities present themselves.

[Operator:]

Our next question comes from Fred Cummings - Elizabeth Park Capital Management.

[Fred Cummings:]

Couple of follow-up questions on credit quality. Could you tell us what is the average LTV of your current book of nonperformers? I know you said that origination, the average LTV was 75%, but after this extensive review, where does that number sit?

[Daniel G. Byrne:]

It tends to vary a little bit by projects. Our feeling is they have gone up on the nonperformings, but we’ve done a very good job, I think, of trying to identify where those valuations are overall and try to address it ultimately with the provision that we did in the fourth quarter.

[Fred Cummings:]

And as relates to your reserve, I don’t know if you disclosed how much of that would be specific versus unallocated out of that $111 million?

[Daniel G. Byrne:]

I don’t think we did disclose that.

[Fred Cummings:]

And would you anticipate having a higher level of OREO as you work through some of these residential construction projects?

[Harold B. Gilkey:]

I think that’s a given Fred that what you do is you try to work with the contractors themselves to complete their projects and go through that process. But in addition to that, there are times where you would take other aggressive action and take deeds into foreclosure. So, our expectation is that we will move things either off our balance sheet, or develop an appropriate workout plan, or to add to our OREO. So, my feeling is that that always happens, but I don’t see it as significant drag. It will be there probably for most of ‘08.

[Fred Cummings:]

And then, lastly, can you tell us when your next scheduled regulatory exam is? Because I think, for the industry, the one risk factor may be the regulators weighing in and concluding that some of these reserve levels are not adequate. You can even give me your thoughts on that hypothesis of mine.

[Harold B. Gilkey:]

There is risk at all levels. We’re scheduled for a safety and soundness exam at Golf Savings Bank, I think, in the second quarter and I feel very comfortable with that portfolio because it’s substantially residential loans that are well underwritten and that’s why I feel comfortable with that position. I think we have one delinquency and one OREO in that portfolio now, so I feel very comfortable with that position. And the last exam that was on that portfolio, they met our expectations; what we did was accepted by them. I think that our next safety and soundness exam for Sterling Savings Bank is scheduled for the latter part of this year or the first part of next year, and so I believe that your thesis may have some validity but by the time that we get there, the cycle will have clearly identified. And in our last exam, which was latter part of last year, was after the subprime crisis was notified, and we had minimal changes in evaluations. Over time, the regulators have felt very comfortable with our process and discipline in the credit quality. And Fred, given the history of our company being the highly leveraged company, we have stressed that credit administration to be conservative because you just can’t afford to have significant problem areas. And that led us to the diversified portfolio that we have by product line and by geographic marketplace. While there is some stress in certain areas, I feel much more comfortable then if we had all of our eggs in one basket − Southern California or Florida.

[Operator:]

Your next question comes from Brian Hagler - Kennedy Capital.

[Brian Hagler:]

Just a couple of questions. One, maybe a follow-up to Fred’s question; can you tell us, after reviewing all these different construction projects, what the average mark was you took this quarter?

[Daniel G. Byrne:]

Mark-to-market adjustments?

[Brian Hagler:]

No, no. I mean, did you writedown the value of those construction projects by 10% on average, 15%?

[Daniel G. Byrne:]

The way our classification system works it’s really a matter of applying an allowance allocation based on the risk in that portfolio. And so it does very much vary by project and also overall by types of loans, and depending on how severely classified they are. So, it does vary a little bit in that respect.

[Brian Hagler:]

The ones that were maybe the most severely classified, what kind of marks or write downs did you take on those on a percentage basis?

[Daniel G. Byrne:]

Let me see if I’ve got the information on a classification report, Brian. I don’t have it right at my fingertips. You have another question?

[Brian Hagler:]

Yes. And then my second question just has to do with your balance sheet. Historically, I’ve kind of viewed you as one of the little more liability sensitive than a lot of your peers, and unfortunately here it seems to have maybe changed a little bit. Is that due to acquisitions that you’ve made or did you make some changes in your balance sheet that’s led to that in the short term or? Just a little more detail on that would be great.

[Daniel G. Byrne:]

Actually, it’s because of the change in the mix of our portfolio toward more asset sensitive, commercial banking. Residential construction lending has all kind of pushed us in that direction, Brian. But I would tell you that our asset sensitivity is generally out to about 90 days, and then we start to become more liability sensitive by the end of the year. So, initially as rates trend down, we do see a little bit more of the asset re-pricing faster than liabilities, and then it starts to turn around. Obviously, we’re still playing catch-up with the Fed drop last week that will have an impact, and we’re still catching up from the last 100 basis points. So at some point when the Fed is done with the decline in the interest rates, we will start seeing that pick up again.

[Brian Hagler:]

It will take some time to cycle through your deposit in your CD portfolio, but were you able to cut your deposit rates by a meaningful amount?

[Daniel G. Byrne:]

We were trying to decrease that portion that was re-pricing, primarily in the CDs, we ran out brokered and wholesale deposits from a price sensitivity standpoint; that’s one of the reasons why we did show a decline in overall deposit balances right at the end of the year. And then we saw the rise in the advances from the Federal Home Loan Bank and others. We were trying to be aggressive and move our posture where we had been more maybe competitive at the upper end of the scale to more middle of the pack. And we’ve been trying to be aggressive in that area to try to cut our cost of funds as the revenue side has been declining.

[Harold B. Gilkey:]

But the other might be valuable, if you were to talk a little about the TRUP we paid off.

[Daniel G. Byrne:]

That’s one area that we expect to see sizable benefit on that $24 million. At the time that we initiated it, we thought we had about a 500 basis point improvement in the overall cost, and obviously it has gotten even larger and the benefit into the future better as a result of the drop in interest rates.

[Brian Hagler:]

Okay. And can follow up on my first question offline?

[Daniel G. Byrne:]

Soon as we grab it, we’ll provide it to you.

[Operator:]

Your next question comes from Matthew Clark, with KBW.

[Matthew Clark:]

Couple of quick follow-ups. Can you isolate the reserve that you have attributed to the construction loan portfolio now? I think it was somewhere in (80?) or so basis point range at least maybe a couple of quarters ago. I was just curious where that stands today?

[Daniel G. Byrne:]

I’m sorry, the reserves specific to the residential construction portfolio, is that what you’re asking?

[Matthew Clark:]

Or even construction in total? Either one.

[Daniel G. Byrne:]

I may have to follow up on that. I am not sure I’ve got that right at our finger tips, Matt.

[Matthew Clark:]

Okay. And then lastly, can you update us on the communication you’ve had with the FDIC since the North Valley deal has fallen apart. What progress you’ve made along the lines of the internal audit function. I think that you added a Board member with some related experience. I just wanted to get an update there.

[Harold B. Gilkey:]

I can tell you that we’ve made progress during all exams. They leave you with a list of things that are deficient; all of those deficiencies have been addressed to a 100% portion. The open areas are some additional staffing, which we’ve identified and have plugged in, and there is some expanded training that probably will take on a roll for the whole year.

[Operator:]

And at this time I show no further questions.

[Daniel G. Byrne:]

I do have one follow-up response to one of the questions in terms of the residential construction reserves in the allocation. It does amount to about $30 million of the total reserve in our classification process, and I think the ratio is about 164 basis points.

[Operator:]

And I show no further question.

[Harold B. Gilkey:]

In that case let’s complete the Q&A session, and I would like to thank everyone for your participation this morning. We look forward to talking with you again at the end of the first quarter of 2008. Our earnings release is currently scheduled for Monday, April 21, and the following morning we will have a conference call again at 8