Heritage Financial Corporation

Ladies and gentlemen, thank you for standing by and welcome to the Heritage Financial Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. If you shall require assistance during the call, please press star, then zero. As a reminder, this conference is being recorded. I would like to now turn the conference over to our host, President and CEO, Mr. Jeff Deuel. Please go ahead, sir.

Thank you, Selina. Welcome to all who called in and those who may listen in later. This is Jeff Deuel. Attending with me are Don Hinson, Chief Financial Officer, Bryan McDonald, Chief Operating Officer, and Tony Chalfant, Chief Credit Officer. You will recall Tony took over as Chief Credit Officer effective July 1 following the long plan for retirement of Dave Sperling. We're pleased to have Tony join the executive team and bring his deep credit experience to the table. Also, we're pleased to have Dave remaining with us on a part-time basis through January to provide extra capacity on the credit team while we sort out the effects of COVID-19. Our earnings release went out this morning pre-market, and hopefully you've had an opportunity to review it prior to the call. We have also posted a Q2 investor presentation on the investor relations portion of our website. Please refer to the forward-looking statements in the press release. It's good to have another COVID-19 quarter behind us. We continue to operate the bank effectively with all but three branch lobbies closed. When Whidbey Island moved to phase three, we opened lobbies in three of the six locations there. The experience has been okay, but uncertainty around infection rates in other parts of the footprint are causing us to move cautiously from here. About 40% of the team is still working remotely, and we're not rushing to bring them back into the bank. About 90 days ago, the Washington and Oregon governors implemented staged approaches to reopening the economy in each state. They're not identical plans, but fairly similar. and as it stands now, many businesses are operating in the more rural parts of both states, whereas the metro areas of Seattle, Bellevue and Portland have been slow to reopen and many companies still have employees working remotely. We've learned a lot about ourselves and the habits of our customers during the last five months. We're in the process of reassessing our branch heavy model as a result. We're also formulating policies for remote workers post COVID-19, and we're using the current environment to continue to optimize our operations by integrating systems with automation, which will also allow us to do more with the same people and to better serve our customers as we move forward into the future. We'll now move to Don Hinson, who will take a few minutes to cover our financial results, including color on our core operating metrics with some specific comments about credit quality.

Thank you, Jeff. As reported in our earnings release, we recognized a loss of 17 cents per share in Q2 due primarily to a $28.6 million provision for credit losses. However, our pre-tax pre-provision income increased to $21.5 million in Q2 from $20.8 million in Q1. Moving on to the balance sheet, net loan balances increased $790 million in Q2. Of that amount, $856.5 million was due to the SBA PPP loans. Offsetting the impacts of the PPP loans was the decline in utilization rates for operating lines of credit on CNI loans to 26.2% at June 30 from 37.5% at March 31. Bryan McDonald will further discuss this and loan production in a few minutes. Deposits increased $950 million in Q2 due primarily to the deposit accounts that increased or were established as a result of the PPP loans. The most significant increase was in non-interest demand deposits which grew 585 million during Q2, thus increasing non-interest demand deposits to 35.9% of total deposits at June 30 from 30.6% at the end of the prior quarter. In addition, we also experienced significant growth in other non-maturity deposit categories, leaving CDs as the only deposit category showing a decline. We continue to have very strong balance sheet liquidity. At quarter end, we maintain combined credit facilities at the Federal Home Loan Bank and Federal Reserve Bank of over $1 billion, and Fed fund lines at other banks totaling $215 million. In addition, we have unpledged investment securities totaling $619 million, and brokered deposits currently make up less than five basis points of total deposits. Our loan deposit ratio is 83.8%. We continue our longstanding strategy of operating with a balance sheet with low leverage, which we believe will serve us well during our current economic situation. We have also been approved to use the Fed's PPP liquidity facility in conjunction with our PPP lending, but we have not yet needed it. Regarding credit quality, our net charge-offs for Q2 were approximately $2 million. A substantial portion of this amount was due to one charge-off in the amount of $1.7 million, related to a borrower who was experiencing financial difficulties not related to COVID-19. The entire loan balance was charged off due to issues with the collateral, but we are hopeful that we will recover a portion of this amount over time. Even during this pandemic, our non-accrual loans and potential problem loans actually decreased slightly in the prior quarter as we continue to proactively manage the portfolio. We are carefully monitoring our exposure to high-risk industries during this pandemic. Our commercial exposure to at-risk categories excluding PPP is relatively low at $564 million, or just less than 15% of the portfolio, and primarily includes outstanding balances in the following categories. Healthcare, $251 million, or 6.6% of the portfolio. Hotels, $126 million, or 3.3% of the portfolio. restaurants, 76 million, or 2.0% of the portfolio. Other high-risk categories are senior living, recreation and entertainment, transportation, including ground and air. Page 21 of our investor presentation has more information on our at-risk industries. Moving on to loan modifications, at the end of Q2, we had modified 839 commercial loans for a total of approximately $527 million, with approximately 56% being interest-only deferrals, 36% being full payment deferrals, and the remainder being other modification structures. Almost all modifications were for 90 days. While consumer loan modifications in number are higher than on the commercial loan portfolio, the dollar amount of consumer loan modifications is less than 5% of commercial loan modifications. while we are taking a conservative approach to risk rating and leaving modified loans at their pre-pandemic risk rating if it is clear that the operating entity will quickly return to its pre-pandemic performance. In total, as of June 30, we have modified 591 million or 12.7% of the loan portfolio, 15.5% ex-PPP loans. Of this amount, 28 million have been granted a second modification as of June 30. We have downgraded 124 of these modified loans, totaling $122 million in response to pandemic-related issues. Most of these downgrades occurred at the time of the modification. In addition, we downgraded another $50.5 million of loans due to COVID-19 that did not receive a modification. Most of our COVID-19 downgrades are to watch and are not included in potential POM loan numbers. Our expectations for the next round of modifications is that we'll see deterioration, a bar of sustainability, and some downgrades to substandard. However, we also expect to see fewer modifications in the second round since some businesses, such as medical, dental practitioners, are back up and running. We are just now reaching the expiration of the first round of modifications, but so far, second requests have been nominal. The provision for credit losses for Q2 was $28.6 million compared to $7.9 million in Q1. The total provision for Q2 included a provision for unfunded commitments in the amount of $2.6 million due to a combination of an increase in forecasted loss rates and the lower utilization rates I previously mentioned. The increase in provisions for loan losses was due mostly to worsening economic forecasts from the one used for the Q1 allowance for credit losses. At the end of Q2, the allowance for credit losses on loans increased to 1.53% of total loans for 1.23% at the end of Q1. Excluding PPP loans, which are guaranteed and not provided for, the allowance for credit losses on loans was at 1.88% at June 30. As a result of the increase in the allowance and the decrease in non-accrual loans, the allowance to non-accrual loans increased 213% at the end of Q2 from 139% at the end of Q1. The magnitude of future provisions will be dependent on a combination of factors, including economic forecast, charge-off experience, and loan growth. Our net interest margin decreased 42 basis points in Q2. This occurred due to a combination of factors, including the impact on floating rate instruments from the 150 basis points of rate cuts in March, New loans and investments having lower than current portfolio rates due to a low yield curve, a higher percentage of lower yielding overnight cash balances, and the PPP loans, which have a much lower yield than the rest of the loan portfolio. Partially offsetting the lower loan investment yields was a decrease in the cost of deposits. Costs decreased in all categories of deposits, with the cost of total deposits decreasing 11 basis points in Q2. Although we experienced margin compression in 2Q, net interest income increased 3.6% from the prior quarter due to the impact of the PPP loans. Noninterest expense decreased slightly from the prior quarter due mostly to a $579,000 decrease in comp and benefits. This decrease was a result of the deferred cost of approximately $900,000 associated with the PPP loan originations. partially offsetting the expense benefit from the PPP loan originations was an increase of $212,000 in overtime expenses due mostly to PPP loan processing and $410,000 in bonus pay to retail branch staff due to customer-facing interactions during the COVID-19 pandemic. We do not expect these Q2 expenses to repeat themselves in Q3. Professional services increased 792,000 from the prior quarter due to the implementation of Heritage Direct, our new mobile and online commercial banking platform which we discussed last quarter. Although initially expected to be completed in Q3, we were able to complete this implementation of Heritage Direct in Q2. Approximately $1.1 million of the $2.2 million of professional service expense in Q2 was due to the implementation and won't be recurring. And finally, moving on to capital, we remain well capitalized for all regulatory capital ratios. Although our TCE ratio dropped 8.5% at June 30, the ratio is 9.9% when you remove the impact of the PPP loans. Yesterday, the Board declared a 20-cent dividend, which is unchanged from the prior quarter. Based on our capital position and long-term outlook, we do not believe the loss in Q2 should impact the dividend level for this quarter. However, we are continually monitoring our capital position and our ability to pay dividends in the future. Bryan McDonald will now have an update on loan production and the PPP status.