Lynn Fuller - Chairman and CEO Bruce Lee - President Bryan McKeag - EVP and CFO Drew Townsend - EVP and CCO.

Jeff Rulis - DA Davidson Nathan Race - Piper Jaffray Damon DelMonte - KBW Andrew Liesch - Sandler O’Neill.

Greetings and welcome to the Heartland Financial USA, Inc First Quarter 2018 Conference Call. This afternoon, Heartland distributed its first quarter press release and hopefully, you’ve had a chance to review the results. If there is anyone on this call who did not receive a copy, you may access it at Heartland’s website at www.htlf.com.

With us today from management are Lynn Fuller, Chairman and Chief Executive Officer; Bruce Lee, President and Bryan McKeag, Executive Vice President and Chief Financial Officer. Management will provide a brief summary of the quarter and then we will open up the call to your questions.

Before we begin the presentation, I would like to remind everyone that some of the information 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 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 website or the SEC’s website. At this time, all participants are in a listen-only mode. [Operator Instructions] As a reminder, this conference is being recorded.

At this time, I will now turn the call over to Mr. Lynn Fuller at Heartland. Please go ahead, sir..

Thank you, Dana and good afternoon. We appreciate everyone joining us today as we discuss Heartland’s performance, reaching new heights in the first quarter of 2018. For the next few minutes, I'll touch on the highlights for the quarter.

I’ll then turn the call over to Heartland’s President, Bruce Lee who will cover progress on our key operating strategies. Then Bryan McKeag, our EVP and CFO will provide additional color on Heartland’s quarterly results.

Drew Townsend, our EVP and Chief Credit Officer is also with us today and will be available to answer questions on credit related topics. Well, I'll begin my remarks this afternoon with a nod to the Heartland team as we passed our much anticipated milestone of 10 billion in assets in the first quarter.

And while we passed this milestone, we continued toward our goal of 12 billion by mid-2019 with the acquisition of Lubbock next month. This truly is an exciting time for Heartland. While Heartland reported a very good quarter with net income available to common shareholders of 23.3 million, that's a 29% increase over the same quarter last year.

We had several accomplishments during the quarter, including closing the Signature Bank acquisition on February 23 as well as organic growth in both loans and deposits. We're very pleased to see a solid increase in our net interest margin, which increased by 10 basis points year-over-year to 4.26% on a fully tax equivalent basis.

Annualized return on average common equity for the quarter was 9.32% and return on average tangible common equity was 13.03%. Another positive trend for the quarter, Heartland’s tangible common equity ratio ended the quarter at 7.59%, which was 9 basis points over the same quarter a year ago.

Likewise, book value and tangible book value per common share increased over the same quarter a year ago to $33.81 and $23.79 respectively.

Following several quarters of progress on our efficiency ratio, this metric picked up for the quarter with a flurry of merger related expenses and restructuring of mortgage as we ended the first quarter at 68.21%. Following my comments, Bruce Lee will address mortgage restructuring and Bryan McKeag will address non-interest expense in more detail.

The credit quality remained sound with non-performing assets and asset quality ratios consistent with the prior quarter. The first quarter of 2018 was very active on the M&A front. In February, we closed on the purchase of Signature Bank shares in the Minneapolis metropolitan area.

Signature Bank was merged into our member bank, Minnesota Bank & Trust and their system integration took place on April 20. This acquisition puts us even closer to our long term goal of 1 billion in assets in Minnesota, one of the 12 states where Heartland operates.

Further, with respect to M&A, we will only pursue transactions that are accretive to our current shareholders’ earnings per share that produce a minimum internal rate of return of 15% based on conservative assumptions and a maximum earnback of 3 to 4 years.

We are also committed to achieving our goal to reach 1 billion or more in assets in each state where Heartland operates. Currently, four of 10 charters have assets in excess of 1 billion and this year's goal is for six of 11 charters to exceed 1 billion.

In concluding my comments today, I'm pleased to report that at its April meeting, the Heartland Board of Directors authorized a dividend of $0.13 per common share payable on June 2. I’ll now turn the call over to Bruce Lee, Heartland’s President who will provide an overview of the company's strategic initiatives.

Bruce?.

Thank you, Lynn. Good afternoon. We are reaching new heights across the company. As Lynn shared, our total assets topped $10 billion for the first time in our history. In Q1, we completed the transaction to add Signature Bank in Minnesota to the Heartland group and we delivered organic growth in our loan and deposit portfolios.

Last week, we successfully completed the technology conversion in Minnesota and the expanded Minnesota Bank & Trust charter is well positioned for growth in the attractive Twin Cities commercial market.

In the coming weeks, we expect to successfully complete the transaction to acquire FirstBank Lubbock and add 1 billion in assets and secure a solid position in the high growth Texas market.

Today, I will share detailed first quarter 2018 results across our revenue producing business lines and provide an update on some significant activities in our member banks, business units and discuss key credit quality metrics. I am pleased to report that for the third consecutive quarter, we delivered organic loan growth.

Our loan portfolio increased by $354 million from year end and has grown nearly $1.4 billion or 26% from first quarter 2017. During the quarter, organic loan growth totaled $30 million. A key component of this growth was our commercial and agricultural portfolios which had $56 million in organic loan growth this quarter.

Across the country, our bankers are reporting strong lending pipelines and our commercial customers are expressing optimism about continued business growth. Equally positive is our growth in deposits. We delivered $395 million of deposit growth in the first quarter, representing an increase of nearly $1.5 billion or 20% year-over-year.

Organic growth contributed $37 million or nearly 10% of deposit growth in the first quarter. Additionally, our focus on growing non-time deposits is continuing to put Heartland in an enviable position compared even to our high performing peers. During the quarter, non-time deposits grew by approximately $407 million.

Of significant importance is the continuing favorable shift in our deposit mix toward non-time deposits. Non-time deposits now account for 89% of our total deposits, up from 88% one year ago. Likewise, non-interest bearing demand deposits now constitute almost 36% of the mix, up from 33% one year ago.

Our core retail business delivered a solid 32% increase in new customer account openings year-over-year. We introduced online account openings in October of last year and now we are seeing nearly 10% of new customers opening their accounts online. Now, switching to service charges and fees.

Overall, service charges and fees for the quarter were $622,000 higher than the first quarter 2017, which is a 7% increase year-over-year. Trust fees increased by $1 million, up 29% from first quarter 2017 and commercial card continued to deliver impressive results, up $440,000 or 28% as compared to last quarter.

Next, I would like to highlight some significant changes in our mortgage business unit and discuss how these changes have a positive impact on financial performance in 2018. In 2017, our mortgage business delivered disappointing results.

We have taken bold measures to reduce costs and modernize our back office operations to improve customer experience and ongoing financial performance. In the first quarter, we began the restructuring of our operations and in the second quarter, we will complete the move to an outsourced mortgage processing model.

In the first quarter, we recorded $2.6 million in restructuring costs tied to the change in our model. The cost cover the upgrades in technology as well as severance expenses related to the reduction in approximately 100 staff positions.

When completed, we expect to realize savings of more than $1 million per quarter, primarily in fixed personnel, technology and overhead costs.

Additionally, our new model trims several days off the process from application to closing, fixes and lowers the cost of processing each loan and makes us more than competitive by providing a contemporary technology solution that delivers a better experience for our customers, including online application capabilities and an online customer portal that allows customers to track the status of their loans on a real time basis.

We'll be operating dual systems through the second quarter and will begin to realize the full benefit of cost savings in the third quarter of this year. We anticipate these changes will return our mortgage operation back to profitability for the second half of 2018.

Overall, we are pleased with first quarter revenue performance and feel we have significant momentum to deliver continued positive results. Next, I will provide highlights of the key credit metrics for Heartland.

I'm pleased to report that we continue to see improvement in credit quality, as non-performing loans continue to represent less than 1% of total loans and more broadly, total non-performing assets, as a percentage of total assets, represent only 0.77%. Delinquency totals are at the lowest levels reported since the fourth quarter of 2014.

And for the first quarter 2018 are 0.21% of loans. Non-pass rated loans increased slightly to 6.43% of total loans, up from 6% from previous quarter, primarily due to loans acquired in the Signature Bank acquisition. This continues to compare favorably to the levels over the past several years.

Lastly, net charge-offs for the first quarter of 2018 were $1.3 million, the lowest level in almost two years. Finally, I'd like to share two exciting leadership announcements. First, we are pleased to welcome Ken Brooks, Past President of Signature Bank and his team to Heartland.

We closed the Signature Bank acquisition on February 23 and completed the system's conversion on April 20. Ken will lead the expanded Minnesota Bank & Trust charter. And secondly, I am pleased to share that Wendy Reynolds has been appointed President and CEO of Morrill & Janes Bank in Kansas City.

Wendy has been a member of the Heartland Colorado team for over eight years and has a proven track record of growing market share and developing long lasting customer relationships. With that, I'll now turn the call over to Bryan McKeag for more detail on our quarterly financial results..

Thanks, Bruce and good afternoon. As both Lynn and Bruce have described, we made progress on a lot of fronts this quarter, so I’ll try to add some more color to their comments. Starting with the tangible common equity ratio, which increased 6 basis points to 7.59%.

The increase in retained earnings this quarter added 38 basis points, which was offset by the acquisition of Signature, which reduced the ratio by 18 basis points and the reduction in market value of our investments and derivatives also reduced the ratio by 14 basis points.

Bruce has already commented on loans and deposits, so I will only comment on a couple of other balance sheet items. First, investments available for sale decreased 189 million and investments held to maturity declined $4 million during the quarter.

The total investment portfolio ended the quarter at just over $2.3 billion, representing slightly less than 23% of assets. The tax equivalent yield on the portfolio decreased 4 basis points for the quarter to 2.87%. The duration for the available for sale portfolio was just over 4.5 years.

Second, the allowance for loan losses, which represents -- which as a percentage of loans remained unchanged for the first quarter at 0.87%. As mentioned in previous quarters, over 1.6 billion of loans from our most recent acquisitions are covered by valuation and PCI reserves, totaling 41.9 million or 2.5%.

Excluding these loans from total loans would result in the allowance to loans ratio of 1.14% as of March 31. Now, moving to the income statement. Net interest income totaled 91.6 million this quarter, down 1.3 million from the prior quarter.

The decline was primarily driven by two fewer days in the quarter, which reduced net interest income by approximately $2 million. The net interest margin on a tax equivalent basis declined slightly to 4.26%, which is down 4 basis points from last quarter.

Loan yields decreased 10 basis points during the quarter due to lower accretion of purchase accounting discounts and the reduced benefit on tax exempt interest due to the new lower federal tax rate.

Investment yields also declined 4 basis points, again largely due to the impact of the lower tax rate, which was partially offset by a reduction in premium amortization. In total, the new tax rate reduced the tax equivalent net interest margin by about 8 to 10 basis points.

Interest costs on deposits and borrowings increased 4 basis points compared to last quarter and this quarter, the net interest margin includes 22 basis points from the accretion of purchase accounting discounts, which compares to 29 basis points in the prior quarter.

Net interest income totaled 24.7 million for the quarter, down $812,000 from last quarter. When compared to last quarter, gain on sale loans was relatively flat, down $239,000 and loan servicing net revenue was up $354,000 due to lower MSR amortization, reflecting lower levels of loan payments.

Also, other non-interest income was down 1.2 million as last quarter included a $1.3 million gain from repurchase of some of our trust preferred securities. Switching to non-interest expense, total non-interest expense was 83.6 million this quarter, an increase of 5.8 million over last quarter.

This quarter M&A and system conversion related costs were flat to last quarter at $1 million. Also, as previously mentioned, this quarter expenses include 2.6 million of mortgage restructuring expenses. Our largest expense category salary and benefits increased 5.4 million compared to last quarter.

There were several items that impacted this category, including costs related to our new Signature personnel as well as higher incentive and retirement plan costs due to quarter-over-quarter accrual changes. For the quarter, the efficiency ratio was 68.21%, up from 62.26% last quarter.

The first quarter efficiency ratio is typically the most challenging of the year, as there are fewer business days and mortgage activity is generally slow during the first quarter. On a seasonal view, the ratio was down 174 basis points compared to 69.95% for the first quarter last year.

Also, similar to the net interest margin, the efficiency ratio was negatively impacted by approximately 115 basis points due to the lower federal tax rate. Therefore, on a truly comparative basis, this quarter's efficiency ratio was down almost 300 basis points from last year. So we're off to a much better start this year.

We also expect the ratio to show significant improvement in the last half of 2018 when we'll start to see the benefits of our mortgage restructuring and the cost saves and scale impacts of our 2018 acquisitions.

The reported effective tax rate for the quarter was 18.04%, reflecting the new tax rates and a tax benefit of $600,000 related to the vesting of restricted stock awards this quarter. We believe the normalized tax rate going forward to be around 22% to 23%.

Next, I'll share some expectations for Heartland’s core results for the remainder of 2018 and these exclude the pending Texas acquisition. First, loan and deposit growth on an annualized percentage basis is expected to be in the low -- in the mid-single digits.

Net interest margin on a tax equivalent basis should be in the plus or minus 4.2% range, as we expect some decrease in current run rate of purchase accounting accretion and some pressure on deposit pricing. Provision for loan losses is expected to be in the current range of 4 million to 5 million per quarter.

Mortgage production is expected to show seasonal improvement over the next two quarters. And April pipelines are already showing an improvement of over 25%, which is encouraging given that we are in the midst of our restructuring.

Core fee income, excluding mortgage and security gains, is expected to show annualized increases nearing 10% from current run rates as we continue to have strong corporate credit card growth and sell into our newly acquired customer bases. And lastly, core expenses excluding M&A and restructuring costs are expected to be relatively flat next quarter.

And then as Bruce mentioned, we should begin to get the benefits of the mortgage restructuring, resulting in a decline in core expenses in the last half of 2018.

One additional comment regarding our mortgage operation and that is due to the significant reduction in infrastructure from the restructuring and the changes in reporting structure we made over a year ago, that was to have the sales staff report directly to our bank Presidents, we no longer consider mortgage to be a separate business segment and will discontinue separate segment reporting in our 10-Qs and 10-Ks going forward.

Finally, I'd like to remind everyone of some of the impacts of the FirstBank Lubbock acquisition, which we expect to close mid-May of this year. First, the addition of FirstBank will increase loans held to maturity by 680 million, net of a loan mark in the 2.5% range. Investments should increase 170 million. Total deposits will increase 870 million.

FirstBank carries a net interest margin in the 4.15% to 4.2% range and has a core net interest – non-interest income run rate of $6 million per quarter and has an efficiency ratio in the low-60s percent range.

Second, at closing, we will transfer $17.5 million of cash and issue approximately 3.3 million of Heartland common stock to FirstBank’s shareholders, which will increase Heartland’s common equity by about 180 million. We are currently estimating goodwill at 115 million and the core deposit intangible at 8.5 million.

These estimates obviously could change once all the fair value marks are finalized and will also depend on our closing stock price on the date of close.

Lastly, we expect the integration and conversion costs will be near $2 million spread over the next two quarters and with the systems conversion currently planned for mid-third quarter, we will not begin to realize the estimated 25% cost saves until the fourth quarter of 2018. And with that, I'll turn the call back over to Lynn..

Thank you, Bryan. Now, we'll open the phone lines for questions from our analysts..

[Operator Instructions] Our first question comes from the line of Jeff Rulis from DA Davidson..

A question Bryan on the -- just following up on the margin, I caught the 8 to 10 impact of the tax reform, but what was the sequential accretion..

Yeah. It was down about seven basis points, last quarter was 29 basis points, this quarter is 22 basis points..

Okay.

So if we're excluding, that's like a 398 core, is that?.

Well, no, it would be the 426 minus the 22. So just about 404..

Okay. Got it. Okay. And then the -- do you anticipate additional mortgage risk.

I got the guidance on the expense, but are there additional mortgage restructuring charges to be expected in 2Q?.

Yes. We don't think so. Obviously, we've made estimates and we'll see how those turn out, but the plan is that we should have picked up all the severance and all the transition costs for systems, which is the bulk of the restructuring that we're doing..

And then maybe one last one, just broadly speaking, the geography of the growth that you are seeing or lack thereof, I mean if you could take it by market and say, this area is growing particularly well or this -- we're seeing some challenges or some competition in some region.

Any color you could provide on the organic loan growth front, that would be great?.

Yeah. Jeff, this is Bruce and then I'll let Drew and also Lynn comment. But I'd say, it's pretty broad right now. We're seeing growth in new business occurring across all of our markets. Where we are experiencing some payoff is really in Colorado this quarter.

They had nice new business, but we did have some previously scheduled construction loans that paid off during the quarter and we weren’t able to fully replace those, but the new business origination is broad and it's really across the board..

Jeff, this is Drew. I don't really have much to add to Bruce's comment. I'm looking at a document right now, I would say, a highlight market for us was maybe Arizona. But beyond that, it was pretty widespread, which is positive..

Our next question comes from the line of Nathan Race from Piper Jaffray..

Just want to start on the reserve build this quarter, Drew, appreciate your earlier comments, but just curious if you can kind of speak to the magnitude that we saw this quarter if this is kind of consistent with what we should expect that you guys maybe accrete some interest income as the purchase accounting discount runs off from some of your deals more recently..

Yeah. I'll jump in here. A good bulk of provision there for the allowance move is due to that. Obviously, a provision will move depending upon how much organic growth they have as well and hopefully that will tick up a little bit, so we might have a little more there. And charge offs are really great this quarter. They're only 1.3 million.

I'm not going to knock on wood. I don't think we see anything big coming down the pike, but if that continues, I think you'll see the transition of the purchase accounting book similar to what it is. That's why I think we're going to see provisions in that $4 million to $5 million range going forward..

And then just thinking about the core margin going forward, I imagine you got First Lubbock coming on the books at some point in the second or maybe early third quarter and I think that’s supposed to be margin dilutive when you back out the purchase accounting accretion and so forth.

So just curious Bryan what your expectations are for the core NIM? We got the rate hike in March and we’ll perhaps get two more later this year.

So just curious on how you think the core NIM will respond to additional rate hikes this year?.

Yeah. I actually think if your far core is about 404, I think their core is in the 415 to maybe even 420 range. So I think they're actually going to help our core and then obviously we’ll have a pretty good size, because their book is pretty good size, the 2.5%, a pretty good size, our discount to them began start to amortize in.

So I think they're actually going to help our margin, especially early on with the purchase accounting..

And then if I could just sneak one last one on First Lubbock, any expectations on when that deal will actually close..

We're hoping mid-May..

Our next question comes from the line of Damon DelMonte from KBW..

Just a quick questions. I may have looked at the wrong press release, but did you guys typically show the total loans by quarter for all the subsidiary banks.

I was just wondering, do you know what the number of banks that showed increases quarter-over-quarter was?.

Organically, I believe we only had two banks that did not show organic growth..

Okay..

And Damon, just the reason we pulled that out is we do a fair amount of moving participations around the company and so you know it does skew it a bit when you see which bank may have looked like it had more or less growth, it could be skewed by that purchase accounting.

So we kind of felt like it was better to look at the assets and then deposits to really get a good size base for the different franchises..

Okay. And then with respect to deposit betas, could you just provide a little color as to what you're seeing across your very broad footprint that you have.

Are there certain markets that are seeing greater pressure on deposit costs versus others and what are some of the dynamics there?.

I'll start off, just to say, we typically think our deposit betas should be in the 40% range for non-maturities and the 60 to -- or the 80 to 90 for non or for time I should say. Our deposit change has been about 15 to 17 basis points in those two categories over the last year and we've obviously had about 100% move in the fed rates.

So we're about half or a little less than half of our -- what we think our betas have -- should be or have been historically I should say. I’ll let Bruce maybe talk about where we might, by market, be seeing more pressure..

Yeah. Damon, I would say that we feel much more pressure in the Midwest on rates. It's much more competitive than in our Western markets. We're not feeling the price pressure quite as strongly out west as we do here in the Midwest. But we’ve been very pleased with our -- how we've been able to contain our betas –.

And still get positive growth –.

Right. In both loans and deposits. So we're very happy with what's occurred so far. We clearly are preparing to be more aggressive if we need to and we’ll have to be that way in the Midwest before the Western markets..

And then just my last question, Bryan, when you were giving your guidance for loan growth, did you say low single digits or mid-single digits?.

Yeah. Mid-single -- I kind of -- I misread. It was mid..

[Operator Instructions] Our next question comes from the line of Andrew Liesch from Sandler O’Neill..

Just you covered most of my questions, just one on M&A, just -- but just curious your sense on like what power conversations going with prospective targets and then regionally if there's any areas that are more active than others..

We're pretty balanced right now Midwest and West. I'd say that biggest issue is the competitive pricing. And as I said in my comments, we're not going to waver on the key financial metrics that we have in our modeling.

I mean, it absolutely has to be accretive to current shareholders, PPS, on conservative estimates going forward, we need a minimum 15% internal rate of return and we want an earnback within three to four years and our stock price is pretty well positioned compared to most of the competitors we run into.

So we can be competitive, but we have lost by very, very small differences on a few deals. Our model is still seen as the preferred model for many of the community banks that we talk to. So we have that social benefit going for us, but if somebody is willing to be overly aggressive on pricing, we're probably going to end up coming in second..

Our next question comes from the line of Nathan Race from Piper Jaffray..

Hey, appreciate taking the follow-up. Just want to follow-up on the tax rate. Bryan, I think you mentioned 21% to 23% or 22% to 23% as a good rate, and I think that’s a little higher than what you were thinking last quarter. Is that just a function of you guys going through the process more so and let a tax reform this quarter.

Just want to make sure I got that right..

Yeah. I think so. I think we're continuing to learn. Some of the things that the tax law said was not deductible anymore or kind of some of the bigger things and trying to also then layer in all of our state taxes because we're in so many states, that does get a little bit tricky. So yeah, I might be up a percentage point from where we thought.

Hopefully, I'm in the ballpark and we're still learning. I mean, it's only a quarter in, so -- but I think 20 -- 22 at the most, 23 from what I know right now should be a pretty decent run rate..

Okay. Got it. I appreciate that.

And then just going back to the integration with Lubbock, just curious I think the plan initially was to let their mortgage operation kind of run as a separate entity, but I guess I'm just curious if that thinking has changed in light of the restructuring that you guys are doing within your legacy division?.

Nathan, this is Bruce. No. Our strategy for PrimeWest, which is FirstBank Lubbock’s mortgage operation will remain the same. We're going to leave them operate as a standalone autonomous group as we work through our new model in the Heartland mortgage world..

There are no further questions at this time. I would like to turn the floor back over to Mr. Fuller for closing comments..

accountability for sales and sales management, organic and acquired growth, enhanced customer experience, employee engagement and operating efficiency. And last, I want to remind our shareholders and analysts that our annual meeting of stockholders will be held next month on Wednesday May 16 6 PM Central Time at the Hotel Julien Dubuque.

We certainly hope and look forward to seeing all of you there and I'd like to thank everyone for joining us today and hope you can join us again at our next quarterly conference call, which will be laid in July. Have a good evening, everyone..

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation..