Heritage Financial Corporation

Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial Quarterly Earnings 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 should require offline assistance, you may depress star then zero. As a reminder, today's call is being recorded. Replay information will be given out at the conclusion of the conference. I will now turn the conference over to your host, President and CEO, Jeff Deuel. Please go ahead, sir.

Thank you, Kevin. Welcome to all who called in and those who may listen later. This is Jeff Deuel, CEO of Heritage. Attending with me are Don Hinson, our Chief Financial Officer, and Bryan McDonald, our Chief Operating Officer. Our earnings release went out this morning pre-market, and hopefully you have had an opportunity to review it prior to the call. We have also posted a third quarter investor presentation on the investor relations portion of our website. please refer to the forward-looking statements in the press release. We are pleased with our performance in the third quarter. We continue to operate the bank effectively with the majority of our branch lobbies open by appointment only and about 40% of our workforce working remotely. Despite the challenging circumstances, we've adapted and this operating model has worked well for us. and actually has helped us identify some new areas for efficiencies and increased productivity. We have reached something of a plateau with regard to reopening the economy in the two states where we operate. The major metro areas are still generally operating in a more limited fashion than the less populated rural parts of our footprint. The downtown areas of Seattle and Portland feel pretty empty, but there's a lot more movement outside the core metro areas. We expect to remain in the current level of activity until we have some relief from a vaccine. We announced the consolidation and closure of nine branches or 15% of our locations. This move is in response to our ongoing efforts to improve efficiency and at the same time respond to the evolution of the industry overall. We continue to focus on digital enhancements in the back office to continue to improve the customer experience. Our goal is to optimize operations by integrating systems with process automation, which will allow us to do more with the same workforce and also better serve our customers. We'll now move on 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 and CECL.

Thank you, Jeff. As reported in our earnings release, We recognized earnings of 46 cents per share in Q3 and an ROA of 1%. We also showed improvement in our efficiency ratio from the prior quarter in spite of a lower margin. Moving on to the balance sheet, net loan balances were relatively flat compared to Q2 levels. We had an increase in CRE loans and commercial construction loans, this being offset by decreases in CNI and consumer loans. Impacting CNI was a continued decline in utilization rates for operating lines of credit to 23.3% at September 30 from 26.2% at June 30. Consumer loan balances are decreasing due to indirect auto loans, which we ceased originating earlier this year. Brian McDonald will discuss loan production in a few minutes. Deposits increased $121 million in Q3. due primarily to a combination of new deposit relationships obtained in conjunction with the SBA PPP lending process and existing customers maintaining higher cash balances. 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 and Fed Fund Alliance and other banks of over $1 billion. In addition, we have unpledged investment securities and overnight cash balances totaling over $1 billion. and Broker Deposits currently make up less than five basis points of total deposits. Our loan deposit ratio is 82%. We continue our longstanding strategy of operating a balance sheet with low leverage, which we believe will serve us well in our current economic situation. Regarding credit quality, our net charge-offs for Q3 were $481,000. The bulk of these charge-offs were due to two C&I borrowers impacted by COVID-19. We also experienced an increase in non-accrual and potential problem loans due to the continued impacts of COVID-19. The increase in non-accrual loans was due primarily to three commercial lending relationships totaling $17.4 million related to COVID impact in high-risk industries. The increase in potential problem loans was due mostly to loans that had been modified under the CARES Act provisions that showed signs of credit weakness. Moving on to loan modifications, of the expiring first round of modifications, 21% have received second modifications. At the end of Q3, we had 260 loans that were in payment deferral modification status, totaling approximately $117 million, which represents 3.1% of the loan portfolio ex PPP loans. At September 30, approximately 42% of these current deferrals were interest-only payments and 58% were full payment deferrals. Eighty-one percent of the loans in payment deferral status are on their second modification. Of the 117 million of loans in modification status at the end of Q3, approximately 41% are loans related to either the hotel or restaurant industry, which are two high-risk industries in our portfolio most significantly impacted by the COVID shutdown. Provision for credit losses for Q3 was $2.7 million compared to $28.6 million in Q2. The provision for Q3 included a provision for increased unfunded commitments in the amount of $410,000 due to a combination of an increase in forecasted loss rates on CNI loans and the lower utilization rates I previously mentioned. At the end of Q3, the allowance for credit losses on loans increased to 1.57% of total loans for 1.53% at the end of Q2. Excluding PPP loans, which are guaranteed and not provided for, the allowance for credit losses on loans was at 1.93% at September 30, an increase from 1.88% at June 30. This higher allowance was due to an increase in the number of individually evaluated loans moving to non-accrual status during the quarter, offset partially by a decrease in the allowance for loans collectively evaluated. The decrease in the allowance for loans collectively evaluated was due to a marginally improved economic forecast. 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 26 basis points in Q3. This occurred due to a combination of new loans and investments having a lower than current portfolio rates due to the low yield curve, the repricing of existing variable rate loans and investments, 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. Deposit costs decreased in all categories with the total cost of deposits decreasing seven basis points in Q3. Non-interest expense decreased $1 million in the prior quarter due primarily to a decrease in professional services. Professional services decreased due to approximately $1.1 million in Q2 costs associated with the implementation of Heritage Direct, our new online and mobile commercial banking platform. Compensation expense decreased in Q3 due mostly to reduced FTE, lower incentive compensation accruals, and a decrease in COVID and PPP-related compensation costs. offset partially by a reduction in deferred compensation cost resulting from higher PPP loan originations in Q2. FDIC premium expense increased due to a combination of higher assessment rates and it being the first quarter over the past four quarters where we did not have any small bank credit remaining to offset the assessment. And finally, moving on to capital, we remain well capitalized for all regulatory capital ratios. Although our TCE ratio was 8.5% at September 30, the ratio is 9.9 when you remove the impact of the PPP loans, which is unchanged from the prior quarter. Yesterday, the Board declared a 20-cent dividend which is consistent with the prior quarter. Based on our capital position and long-term outlook, we believe the continuation of the regular dividend is appropriate. Brian McDonald will now have an update on loan production and SBA PPP.