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.

Hi, this is Andrew. I'm for Jeff Lewis. I saw in the investor deck there is net interest margin excluding accretion, but I was wondering if there's a figure for net interest margin excluding PPP, interest recoveries, and accretion. Thanks. Good morning, Andrew. Thanks for the question. Don, I'll pass that one to you. Sure. Yeah, if we strip out, you might say, everything that happened this last quarter on all those areas, it would probably be about 260 would be the margin, which is really unchanged from the prior quarter if you strip out all those things. Perfect. Thank you. And maybe just one other question on buyback appetite. How does that compare to last quarter? Well, we're not looking to do a lot of buybacks like similar to last quarter. We did about 80,000 to kind of keep the share count about the same. So we don't have a big appetite for buybacks with the TCE ratio again around 7.9. So We'll probably be holding pretty steady on that. Sounds good. Thanks so much. I'll step away. Thank you.

Thank you. Our next question is from the line of Kelly Motus with KBW. Please proceed.

Hi. Good morning. Thanks for the question. I appreciate all the color around expenses and the work you did last year to lower that. And it came in lower than I expected for the quarter. And I think your guidance last time around was about $37 to $38 million a quarter. You said you expect expenses to go up from here. Is that $37 to $38 still kind of a good outlook for the rest of the year given the the increases you see?

Yeah, good morning, Kelly. Yes, that is appropriate for us. I think that the reason why it's a little bit lower is a variety of factors, one of which is we've been working on it for a while. So, you know, we're getting some of the benefits of our efforts. But we've had some folks on our team transition to retirement and we haven't necessarily replaced all of them yet. And I think, too, that like everybody else, we're experiencing, you know, the great relocation, reorientation, whatever you want to call it, in terms of people choosing to do other things and move around. So I think it's a combination of things. But when you consider that we'll be refilling many of those seats And the inflationary impact on wages that we feel is coming at us this year, I think it's safe to say that we will be in that range as the year progresses. Don, anything you'd like to add? Yeah, just I think that we will be back up in that range towards the last half of this year. This next quarter will probably be somewhat transitionary that we may not get there. this next quarter, but I think in the last half of the month.

Thanks. That's helpful. And then looking at your loan growth, it was really strong this quarter, and I appreciate the outlook, I think you said, for high single-digit growth. I see you purchased some resume mortgage during the quarter. I was wondering if that was more of a one-time thing or if there's appetite to purchase more maybe similar amounts going forward and how that factors into your loan growth outlook?

Yeah. Yes, we have not done that before, and it was a good experience for us. It's just another lever that we have to manage the excess cash we have on a balance sheet. I think it's notable to point out that the mortgages we did buy fit very well with our credit box and our risk profile from the standpoint of geographies and the way they were underwritten. So it's not like we've ventured forth and done something really extremely different. I think we probably will continue to potentially utilize that as a lever going forward to help us, you know, start levering up the balance sheet. Don, any thoughts that you have that you want to add? No, I think a lot will depend on where we're at and what spreads we're getting compared to investments. But I think it went well. Again, as Jeff mentioned, we basically used the same underwriting criteria we would if we originated the loans and also in our same geography. So it's not like we're going out away from our risk profile to do these. it's very likely we'll do more, how much will depend on the environment.

Great. And then last question for me tying into liquidity and also just the strong deposit growth you have. Given how much liquidity you have and it's nice to see it getting put to work into loans, can you help us a bit with the deposit side of the balance sheet? expectations for the deposit data for the first 100 basis points of rate hikes and then thereafter. I would assume, given how much liquidity you have, you can kind of temper the impact to funding costs. But just interested in any commentary there. Thank you.

John, you want to take that? Sure. You know, I think with the liquidity in the system, we have betas in our you know, when we do our interest rate risk analysis and the data's are probably average around, you know, 30%. But there's always a lag period when it comes to deposit rate increases. And, you know, I think in this current environment with all the liquidity that's on the balance sheet of banks, that lag period could go further. You know, we get the numerous rate increases that's now forecasted. I could see later in the year that we may need to start raising rates, there's been no current pressure, maybe one-off exceptions. But, you know, we get the last half of the year, we could see some pressure there, but I'm not expecting a lot. Even when we're, even the last cycle, when the rates were higher, you know, our total cost deposits are still pretty low. I don't think it's going to be a big impact.

That's really helpful. Thanks. I'll step back now. I appreciate all the callers.

Thanks, Kelly. Thank you, Ms. Monta. The next question is from the line of Matthew Clark with Piper Sandler. Please proceed.

Good morning, guys. I wanted to touch on the some near-term margin outlook. I think in the prior quarter, you thought 1Q would be the bottom. I know you guys did some SFR purchases. The weighted average rate on new loans is down a little bit. But you have a Fed rate increase here in March, another one, a bigger one in May. I guess, can you just give your thoughts on kind of near-term margin outlook and the trajectory of loan yields from here? Don, you want to take that? Yeah, I'll take that, too. I think I'm really pretty positive about where we're going with, you know, with NEM going in the next few quarters. You know, I just start looking at our overall balance sheet with the amount of cash that we have and say that we get 250 base point increases, which certainly looks likely this next quarter. You know, we could see even our overnight cash, the yields on that go up. around 60 basis points. So, and then, you know, our, if you, you know, if you, you know, strip out the, you know, some of the recoveries because the core loan yields, I think that we're going to see now we've got, you know, I like going to page, you know, Matthew, if you go to obviously page 30 of our investor presentation, that really helps me tell the story of a lot of, you know, what's going to happen to our balance sheet, you know, where we've got, you know, 22% is, you know, over at cash and, you know, we've got a decent amount of our loans that are floating and even some investments, about 10% of our investment portfolio. So I'm pretty optimistic of where the margin is going. You know, some of it will be dependent on the spread that we get on new loans and investments for that matter. But, you know, I think we have hit bottom and we'll start increasing every quarter for this year. Great. Okay, thank you. And then Just on the reserve coverage ratio, down a little bit further here, I think your day one level was 101. I think we had previously thought you might dip below that. Given the growing uncertainty in the macro environment, do you feel like you can dip below day one still at some point here, or do you feel like you can maybe stabilize there? Well, I think that, you know, we're at 101 on day one. We're at 107. You know, we've had, you know, a period of no losses. At the same time, we are factoring in, you know, the inflationary pressures, you know, I guess the potential for a recession in the next year or two. There's certainly some pressure on certain aspects of our portfolio. We're not feeling it now, but we certainly are aware of things like, again, continued things in hotels, restaurants, even office space. What's the need going to be for that? We're monitoring all those things and we're factoring those in in our allowance. I can't predict what's exactly going to happen, but if we don't end up with losses, we'll certainly probably be down to where we were. And there's always a possibility we could be below that. Got it. Okay. And then just on the M&A topic, I know you touched on it, Jeff, in your prepared comments, but can you give us a sense for kind of a change in the level of discussions relative to last quarter and whether or not there's anything, not imminent, but just that's getting any closer to getting done here, maybe by the end of the year? I don't think the environment for M&A has changed much for us, Matt. You know, as we've said for many, many quarters, we've spent a lot of time keeping tabs and keeping in touch with our, you know, the targets we're most interested in. And I think we have a rapport with all of them that if something's going to happen, we'll hear about it. But no, I don't see I don't see what things have changed that would cause us to expect anything in the near term. Okay. And then your other comment around dislocation opportunities that you expect to emerge. Any increased level of conversations with bankers from other banks in the midst of M&A, or are those still kind of on the come? Yeah, we made the same comment last quarter. I think we expected that it would take some time for those opportunities to present themselves. And I think that's still the case. I think we said on the last call, probably later in the year, you know, I think at this point, everyone's still getting sorted out. So I'd say it's on the come. Okay, thank you.

Thank you, Mr. Clark. Once again, to ask a question, press star 1. There are no additional questions waiting at this time, so I will turn the call over to Jeff Duhl for closing remarks.

If there's no more questions, then we'll wrap up the quarter's earnings call. We thank you for your time, your support, and your interest in our ongoing performance, and we look forward to talking with many of you in the coming weeks. Thanks for calling in. Goodbye.

Thank you, Mr. Dole. As a reminder, there will be a replay available after this call. To access the replay, please call 1-866-813-9403 and key in the access code 921221. That concludes today's call. Thank you for your participation. You may now disconnect your line.