Heritage Financial Corporation

Good afternoon. Thank you for attending today's Heritage Financial Corporation Q1 2022 earnings conference call. My name is Hannah, and I will be your moderator for today's call. All lines will be muted during the presentation portion of the call with an opportunity for questions and answers at the end. If you would like to ask a question, please press star 1 on your telephone keypad. I would now like to pass the conference over to our host, Jeff Doole, the CEO of Heritage Financial Corporation. Please go ahead.

Thank you, Hannah. Welcome and good morning to everyone who called in and those who may listen later. This is Jeff Dewell, CEO of Heritage. Attending with me are Don Henson, Chief Financial Officer, Brian McDonald, President and Chief Operating Officer, and Tony Chauvin, Chief Credit Officer. Our earnings release went out this morning pre-market, and hopefully you have had the opportunity to review it prior to the call. We have also posted an updated first quarter investor presentation on the investor relations portion of our website, which can be found at heritagebanknw.com. We will reference the presentation during the call. Please refer to the forward-looking statements in the press release. We're happy to report on the positive progress we have made this quarter. Annualized loan growth, XPPP, was a respectable 9.5% for the quarter. This growth was aided by lower payoffs, higher line utilization, and a pool of purchased residential mortgage loans. We are pleased with the positive trend we see in the number of new commitments and new loan closings. Even with our conservative credit box, we're getting our fair share of the new deal. We continue to see deposit growth with minimal runoff resulting from our branch consolidations in 2021. Our pipeline of loans and deposits is strong, and we expect it to continue to grow through the balance of the year. We maintained our focus on carefully managing expenses with good success, as evidenced in the non-interest expense number, which was down 7% from Q4 levels. Notably, our longstanding focus on credit quality and actively managing our loan portfolio continues to play out well for us as the pandemic recedes. Staying focused on our risk profile has enabled us to continue to report improving credit trends. We also continue to benefit from the recapture of a portion of the reserve bill from 2020. ACL is now settling in at 1.07% XBPP, compared to the pre-pandemic ACL of 1.01%. In spite of lingering COVID concerns, it is exciting to be facing a more normalized and positive business environment for organic growth resulting from the economic vitality of the Pacific Northwest. We'll now move to Don who will take a few minutes to cover our financial results. Thank you, Jeff. As Jeff mentioned, Overall financial performance is very positive in Q1, and I'll be reviewing some of the main drivers of our performance. As I walk through our financial results, unless otherwise noted, all the prior period comparisons will be with the fourth quarter of 2021. Starting with net interest income, there was a decrease of almost $1 million due mostly to a $1.8 million decrease in income from PPP loans. The balance of PPP loans was down to $65 million at quarter end, and its impact on net interest income will lessen as we progress through the year. Partially offsetting this was an increase in income from investment securities. This was due mostly to an increase in average investment balances of $248 million, or 21% from the prior quarter. We expect to continue to be active in investment purchases through our large overnight cash position. Further information on the investment portfolio is shown on page 28 of the investor presentation. The net interest margin was relatively stable from the prior quarter, down only one basis point. Helping the margin in Q1 was the impact of interest recoveries on non-accrual loans which impacted loan yields by 11 basis points in Q1 compared to just one basis point in the prior quarter. Offsetting these positive impacts to margin was the previously mentioned decline in impact from PPP loans and lower overall yields in the investment portfolio, which was due partly to purchasing lower duration securities and partly due to additional interest recognized in Q4 as a result of prepayments on securities. However, even with lower yields, investments helped improve the margin in Q1 due to the leveraging of our cash position. We had another good quarter for deposit growth. Total deposits grew 97 million or 1.5% in Q1, and have grown 458 million or 7.6% year over year. Cost of total deposits were nine basis points for Q1, the same level as the previous two quarters as shown on page 27 of the investor presentation. All of our regulatory capital ratios remain strongly above low capitalized thresholds, and we continue to have a very strong liquidity position. We did experience a decline in our TCE ratio to 7.9%, due to the impact of market rates on the fair value of the available for sale portion of the investment portfolio. Overall, our TCE ratio was lower than historical levels due to significant balance sheet growth, mostly in the form of cash that we have experienced over the last couple of years. You can refer to page 32 of the investment presentation for more specifics on capital and liquidity. Non-interest income decreased 1.3 million from the prior quarter due primarily the $2.7 million gain on sale of property we recognized in Q4, partially offset by an increase in bowling income due to the Q1 recognition of a death benefit. We continue to see nice improvement in our overhead ratio due to the combination of expense management measures and asset growth. Our overhead ratio decreased to 1.95% compared to 2.06% in the prior quarter. Although we have benefited from our expense management measures, we do expect our expenses to increase over the next few quarters due to inflationary pressures on compensation expense and continued technology investments. As occurred throughout 2021, a significant impact to our earnings for Q1 was a reversal of provision for credit losses in the amount of $3.6 million. Factors for the provision reversal included a decrease in the impact of non-accrual loans, a continued improved economic outlook, change in the loan mix, and improvement in overall credit quality metrics. I will now pass the call to Tony, who will have an update on these credit quality metrics. Thank you, Don. I'm pleased to report that credit quality remains strong, and we continue to see improvement across our portfolio. For the first quarter, non-accrual loans declined by $7.2 million, or 30% from our year-end 2021 level, and we don't have any other real estate owned as we've reported in previous quarters. Non-accrual loans are now down 72% from our December 31st, 2020 levels, which was the high point in this credit cycle. As of March 31st, non-accrual loans totaled $16.5 million. This represents 0.43% of total loans and 0.22% of total assets. The significant improvement in the quarter was primarily due to paydowns and payoffs on problem loans that were the result of successful long-term workout strategies. With these payoffs and paydowns, we were able to recover just over $1 million in interest and fees. Also contributing to the decrease, to a lesser extent, was our ability to upgrade two borrowing relationships consisting of three loans back to accrual status. These borrowers had been impacted by COVID, and both have now improved their financial performance to a point where an upgrade was warranted. Over the past few quarters, we've not had any significant new additions to our non-accrual loan totals. Continuing this trend, we did not move any loans to non-accrual status during the quarter. Page 24 of the investor presentation highlights our success in reducing non-performing assets. Criticized loans, those risk-rated special mention as substandard, declined by approximately 5% or $9 million in the first quarter. At just under $175 million, we continued moving towards a level that we would consider normal in a good economy. As of quarter end, criticized loans were $32 million higher than December 31st, 2019, or what we consider to be our pre-pandemic level. As we have been reporting in previous quarters, our hotel portfolio remains the largest contributor to this remaining elevated level. Within this portfolio, we have approximately $63 million of criticized loans. While the underlying properties continue to demonstrate improving cash flow, They are not yet at the level of performance that warrants a return to a past rating. The travel industry is rebounding nicely in 2022, and we would expect to be in a position to upgrade many of these loans in the second half of the year. For more detail on the COVID impacted industries that we continue to closely monitor, please refer to page 23 in the investor presentation. During the first quarter, we experienced charge-offs of $355,000. split fairly evenly between commercial and consumer loans. This was more than offset by recoveries of $849,000, leading to a net recovery position of $494,000 for the quarter. During the quarter, we sold a small pool of 14 problem loans to a third-party investor. The pool included both consumer and commercial loans and totaled $855,000. While there was a small net charge-up for $41,000 on the sale of these loans, we were also able to book $163,000 recovery of interest income. Like other parts of the country, our region continues to be impacted by supply chain and labor shortage issues, as well as the persistent high level of inflation. Despite these challenges, the economies of both Washington and Oregon continue to perform well and have bounced back strongly as COVID-related restrictions have been lifted. We are seeing a more competitive pressure on our loan structures as banks look to deploy their excess liquidity. Heritage Bank has not loosened our underwriting standards as we remain committed to maintaining a moderate risk profile through all business cycles. I'll now turn the call over to Brian, who will have an update on loan production. Thanks, Tony. I'm going to provide detail on our first quarter loan production results, starting with our commercial lending group. For the quarter, our commercial teams closed $225 million in new loan commitments, down from $329 million last quarter, and roughly even with the first quarter of 2021. Please refer to page 18 in the Q1 investor presentation for additional detail on new originated loans over the past five quarters. The commercial loan pipeline ended the first quarter at $527 million, up from $462 million last quarter and down from $540 million at the end of the first quarter of 2021. We have been seeing an increase in new loan requests from customers and prospects since July of 2021 when the governors of Washington and Oregon lifted many of the pandemic restrictions. And we saw this trend accelerate during the first quarter of 2022. Organic loan growth during the quarter was augmented with the purchase of a residential mortgage pool. and negatively impacted by the runoff of both the SBA PPP balances and the indirect loan portfolio, a business line we discontinued in 2020. Loans increased $61 million during the quarter, or a 6.9% annualized rate, excluding the impact of SBA PPP, indirect loan balance declines, and the residential mortgage purchase. Although new loan production was down from Q4 2021, we benefited from higher utilization rates and lower prepayment and payoffs as detailed on slides 19 and 20 of the investor deck. Consumer loan production, the majority of which are home equity lines of credit, was $22 million during the quarter, which is down from $23 million last quarter and up from $16 million in the first quarter of 2021. Moving to interest rates, our average first quarter interest rate for new commercial loans was 3.54%, which is 17 basis points lower than the 3.71% average for last quarter. In addition, the average first quarter rate for all new loans was 3.39%, down 11 basis points from 3.48% last quarter. Of the 11 basis point decline, eight can be attributed to the mortgage pool purchase. Although the marketplace continues to be very competitive, we are seeing the recent rate increases translate into higher quoted rates on new loans. With this, we anticipate Q1 to be the bottom of the current cycle, with our reported loan rates expected to increase from here. The mortgage department closed 37 million of new loans in the first quarter of 2022, compared to 45 million closed in the fourth quarter of 2021. and $43 million in the first quarter of 2021. The mortgage pipeline ended the quarter at $27 million versus $29 million in Q4 and $36 million in the first quarter of 2021. Refinances made up 77% of the pipeline at quarter end. With interest rates rising, we anticipate refinance volumes will decrease and overall mortgage volume will trend down in 2022. I'll now turn the call back to Jeff. Thank you, Brian. As I mentioned earlier, we're very pleased with our performance in the first quarter. We're seeing a nice upswing in organic production across the bank with deals coming from existing customers and new high-quality prospects. We are prepared for high single-digit loan growth, and we are optimistic that level of loan production is achievable for us as the year progresses. We also still believe there will be opportunities to add talents to the team and new customers to the book as a result of dislocation in our markets. We rationalized our expense base last year, and we will continue to focus on expense control in 22, although we do expect to experience inflationary pressures like everyone else. We have also continued to focus on our technology strategy, which is designed to support more efficient operations a more consistent customer experience and positions us well to pivot as bank technology continues to evolve and we continue to grow. As a reminder on page seven of the investor deck, we have included a graphic overview of our technology strategy and you will see that several segments of the Heritage One platform are in production. We will continue to refine these segments and we will be adding additional capabilities in the future. We are also prepared to pursue acquisitions in the three-state region when we see the right opportunities for us. As Don mentioned earlier, our capital levels and our robust liquidity provides us with a strong foundation to address challenges and take advantage of opportunities. That concludes our prepared comments. So, Hannah, we're ready to open up the line to questions that anybody may have.

If you would like to ask a question, please press star followed by one on your telephone keypad. If for any reason you would like to remove that question, please press star followed by two. Again, to ask a question, press star one. As a reminder, if you are using a speakerphone, please remember to pick up your handset before asking your question. We will pause here briefly as questions are registered. The first question is from the line, Jeff Lewis with DA Davidson. Please proceed.