Heritage Financial Corporation

Good afternoon. Thank you for attending today's Heritage Financial Corporation Q2 2022 earnings call. My name is Bethany 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 one on your telephone keypad. I would now like to pass the conference over to our host, Jeff Duell, CEO of Heritage Financial Corporation. Please go ahead.

Thank you, Bethany. Welcome and good morning to everyone who called in and for those who may listen later. This is Jeff Duell, CEO of Heritage Financial. Attending with me are Don Henson, Chief Financial Officer, Brian McDonald, President and Chief Operating Officer, and Tony Sheltman, Chief Credit Officer. Our earnings release went out this morning pre-market, and hopefully you had an opportunity to review it prior to the call. We have also posted an updated second quarter investor presentation on the investor relations portion of our website, which can be found at heritagebankmw.com. We will reference the presentation during the call. Please refer to the forward-looking statements in the press release. We are happy to report another solid quarter in Q2. Organic loan growth was 5.6% annualized and was aided by lower payoffs, higher line utilization, and a pool of purchase residential mortgage loans. Annualized loan growth ex PPP was 11.2% for the quarter. We are pleased with the positive trend we see in the number of new commitments and new loan closings. Our production teams are performing quite well in the current market. We also continue to focus on deposit growth, and although we saw some deposit runoff this past quarter, deposit balances began to pick up again after quarter end. Our pipeline of loans and deposits are strong, and we expect it to continue to grow through the year. We're pleased to report that during the second quarter, we expanded our existing presence in the Portland Vancouver MSA. and gained entry to the Eugene, Oregon market through the hiring of four new commercial banking teams. We believe these new teams will begin to contribute to our new loan and deposit growth in Q3. NIM is improving with the deployment of cash in the loans, higher rates on deposits at the Fed, and increases to the investment portfolio. Don and his team have done a nice job carefully managing our balance sheet over the past couple of years, and we are pleased with the results. We maintained our focus on carefully managing expenses with good success, as evidenced in the overhead ratio of 1.94%. However, we do expect that ratio to shift up a bit over the next couple of quarters with the addition of the new teams. Notably, our longstanding focus on credit quality and actively managing our loan portfolio continues to play out well for us. Staying focused on our moderate risk profile has enabled us to continue to report improving credit trends and provide a good foundation as we face a potential recession. We also continue to benefit from the recapture of the reserve bill from 2020. ACL is now settling in at 1.03% ex-PPP compared to the pre-pandemic ACL of 1.01. 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 was very positive in Q2, 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 first quarter of 2022. Starting with net interest income, there was an increase of $3.1 million due mostly to improved yields on earning assets and the leveraging of cash into investments and loans, partially offset by a decrease in income from PPP loans. PPP loans decreased $54 million to a balance of $11 million at quarter end, and their impact on net interest income decreased by $1.3 million from the prior quarter. The impact from PPP loans will be much less significant for the remainder of the year. Excluding the decline in PPP balances, loans increased $106 million during the quarter, which is up from the increase of $86 million in Q1. In addition, investments increased 341 million due to increased levels of purchasing in Q2 in order to take advantage of improved market rates. As a result of the increases in loans and investments, as well as a decrease of 161 million in total deposits, our interest earning deposits held at other banks decreased 588 million during the quarter. However, interest earning deposits is still at a very healthy 900 million at the end of Q2. which provides opportunities for further growth into higher yielding loans and investments. Due mostly to the leveraging of our cash and higher yields on interest earning assets, our net interest margin increased 20 basis points from the prior quarter. As expected, Q1 appears to be the floor for our net interest margin in this rate cycle and we expect to continue to benefit from the current rate environment and expect additional rate hikes. Growth in loan yields was muted in Q2 by the runoff of PPP loans and a 10 basis point decrease in the impact of interest recoveries on non-accrual loans compared to the prior quarter. As I previously mentioned, we experienced a decline in deposit balances during the quarter. This is not surprising given the overall decline in deposits that banks experienced in Q2. Cost of total deposits were nine basis points for the quarter, the same level as the previous three quarters as shown on page 26 of the investor presentation. We do expect to begin to see incremental increases in the cost of deposits over the coming quarters. All of our regulatory capital ratios remain strongly above well-capitalized thresholds, and we continue to have a very strong liquidity position. Our TCE ratio is at 7.9% unchanged from the prior quarter. This was due to strong earnings and a decrease in total assets offsetting the impact of investment fair value marks on the AOCI portion of equity. Due to the impact of market rates on equity, which is both unrealized and somewhat volatile, we have begun to report the TCE ratio and tangible book value per share both with and without the impact of AOCI. As of the end of Q2, AOCI had an 80 basis point impact on the TCE ratio and $1.76 impact on the tangible book value per share. You can refer to page 31 of the investor presentation for more specifics on capital and liquidity. Non-interest income decreased $1.5 million from the prior quarter due primarily to a $1 million decrease in BOLI income from the Q1 recognition of a death benefit. We have continued to see improvement in our overhead ratio. Our overhead ratio decreased to 1.94% compared to 1.95% in the prior quarter. However, due to a combination of the hiring and production teams, continued technology investments, and inflationary pressures on our internal pay scales, we do expect to see our expenses increase over the next few quarters. As has occurred over the past several quarters, our earnings for Q2 were positively impacted by a reversal of provision for credit losses in the amount of $1.2 million. The reversal was mostly due to a $1.7 million reduction in required allowance for individually evaluated non-accrual loans. In addition, we also lowered the allowance on unfunded commitments by $555,000 due mostly to higher utilization rates. Without these two items, we would not have had a reversal of provision in Q2. I will now pass the call to Tony, who will have an update on our credit quality metrics.