Heritage Financial Corporation

Thank you for standing by and welcome to the Heritage Financial Corporation Q4 2022 earnings conference call. I'll 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'd like to ask a question, please press star followed by one on your telephone keypad. I'd now like to hand the conference over to Jeff Doole, CEO of Heritage. Jeff.

Thank you, Sam. Welcome and good morning to everyone who called in and those who may call in later. This is Jeff Duell, CEO of Heritage Financial. Attending with me are Don Hinson, our Chief Financial Officer, and Brian McDonald, our President and Chief Operating Officer. Tony Shelfant, Chief Credit Officer, will not be joining the call today due to a personal commitment. Our Q4 and full year 2022 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 an updated fourth quarter investor presentation on the investor relations portion of our corporate website. We will reference this presentation during the call. Please refer to the forward-looking statements in the press release. We're very pleased to report another solid quarter and year. We had good organic loan growth. We're pleased with the positive trend we have seen in the number of new commitments and new loan closings from our existing production teams as well as the newer members of our team in Southwest Washington and Oregon. Net interest margin continues to improve with rates moving higher together with careful management of our deposit relationships. We continue to manage expenses. As mentioned in previous quarters, we're experiencing the impacts of inflation-driven expense increases together with the additional expense related to the new teams who joined us in May. You will recall we guided to non-interest expense in the $40 million range, which is where we came in for the quarter. Notably, our longstanding focus on credit quality and actively managing our loan portfolio continues to play out well for us. Staying focused on our conservative risk profile has enabled us to continue to report improving credit trends, and it provides us with a solid foundation as we face into a more difficult economic environment in 2023. We'll now move on to Don, who will take a few minutes to cover our financial results and credit quality metrics.

Thank you, Jeff. As Jeff mentioned, overall financial performance was very positive in Q4, 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 third quarter of 2022. Starting with net interest income, there was an increase of 3.8 million or 6.4% in net interest income due mostly to a higher net interest margin. The net interest margin increased 41 basis points to 3.98% for Q4. This was due mostly to improve yields on earning assets while maintaining a relatively low cost of deposits. We continued the trend of solid loan growth in Q4 and finished the year with loan growth of 380 million or 10.3% ex PPP loan repayments. In addition, yields in a loan portfolio were 4.86% in Q4 which was 35 basis points higher than Q3. Brian McDonald will have an update on loan production and yields in a few minutes. The impact of higher yields on loans and other earning assets was partially offset by a decrease in total earning assets during the quarter due primarily to a decrease in deposits of $313 million or 5% in Q4. Most of this decrease was due to rate-sensitive customers seeking higher yielding investments in addition to a significant portion of customers using excess cash for other purposes, such as asset purchases and owner distributions. Of those seeking higher rates, most are going to brokerage firms to invest in higher rate bonds and T-bills. As an example, the Wealth Management Division at Heritage Bank added $125 million in funds under management from Heritage Bank deposit customers during the quarter. We continue to continue to strategically increase our deposit rates and develop attractive deposit products, as well as working individually with our customers to maintain relationships. As a result of the current rate environment, we expect to continue to experience an increase in the cost of deposits, as well as a decline in some deposit balances. As we have in the past, we may supplement core deposits with broker deposits. However, as of the end of 2022, we did not have any broker deposits on our balance sheet. All of our regulatory capital ratios remain strongly above well-capitalized thresholds. Our TCE ratio is at 8.2%, up from 7.6% at the end of Q3. Although the AOCI impact has decreased, it is still significantly affecting the TCE ratio. As of the end of Q4, AOCI had 130 basis point negative impact on the TCE ratio. In addition, with a loan deposit ratio of 68%, we have plenty of liquidity to continue to grow our loan portfolio. You can refer to page 31 of the investor presentation for more specifics on capital and liquidity. Non-interest expense increased $1.2 million to $40.4 million in Q4. This was due mostly to increases in compensation expense resulting from continued inflationary pressures as well as higher FTE levels as we have been able to reduce the amount of our open positions over the last couple of quarters. Moving on to credit quality, I am very pleased to report that we ended the year with very strong credit quality metrics across our portfolio. During the quarter, we saw continued loan losses and had further reductions in our non-performing assets and criticized loans. As of December 31st, non-accrual loans totaled $5.9 million, and we do not currently hold any OREO. This represents 0.15 percent of total loans and .08% of total assets. We moved one C&I relationship to non-accrual in the fourth quarter in the amount of $605,000. This was more than offset by $933,000 in loans that were either paid in full, made payments that were applied to principal, or returned to accrual status. While non-accrual loans declined by a modest $328,000 during the fourth quarter, we have seen a significant reduction of $17.8 million or 75%, since December 31, 2021. Our delinquent loans, which we define as those over 30 days past due and still accruing, remains low at $5.4 million, or 0.13% of total loans. While this is slightly higher than the previous quarter, most of the difference was connected to three mortgage loans that were part of a loan pool purchase in December, where there was a delay in receiving the payments from the original servicer. Those payments were received in early January. Page 23 of the investor presentation highlights the positive trends in our level of non-performing assets. Criticized loans, those risk-rated special mention and substandard, declined approximately 10% or $15.6 million in the fourth quarter and are now down 26% from year-end 2021. It is worth noting that over the past 12 months, loans risk-rated substandard have declined by 47 million or 42%. As of December 31st, criticized loans totaled 135 million or 3.3% of total loans. That year in 2020, criticized loans were 291 million and our current level represents a decrease of 54% from what we consider to be the high point of this credit cycle. While still high at 25% of criticized loans, our hotel portfolio continues to improve. In the fourth quarter, we saw a reduction of approximately $12 million in criticized loans in this category, primarily from the payoff of one loan. We continue to closely watch our portfolio of office loans. Through the year in 2022, we saw very little deterioration in credit quality. Criticized office loans total approximately $23 million, or 4% of our total portfolio of office loans. For more detail on our criticized loans, please refer to page 24 of the investor presentation. During the fourth quarter, we experienced very low charge-offs of $151,000, all from our consumer portfolio. These consumer losses were low when compared to historical norms and were primarily tied to auto loans, small unsecured lines of credit, and credit cards. The losses were more than offset by recoveries of $359,000, leading to a net recovery of $208,000 for the quarter. A significant portion of the recoveries in the quarter came from the completion of a successful long-term workout strategy for a commercial real estate land development loan. For the full year, we had net recoveries of approximately $1.2 million. This compares favorably to the net charge-offs of $526,000 that we experienced in 2021, also a very strong year when compared to historical performance. As we have stated in previous calls, our average annual net charge-offs for the three-year period 2018 through 2020 was approximately $2.9 million. In 2022, our disciplined credit approach delivered excellent credit quality across portfolios while still realizing solid loan growth. While we recognize that 2023 may present a more challenging economic environment, We remain very well positioned with strong credit quality and a well-diversified loan portfolio. I will now turn the call over to Brian who will have an update on loan production.