Heritage Financial Corporation

Hello everyone and warm welcome to the Heritage Financial Q3 2024 Earnings Call. My name is Emily and I'll be coordinating your call today. After the presentation you will have the opportunity to ask any questions which you can do so by pressing start or by the number one on your telephone keypad. I will now turn the call over to CEO Jeff Dool to begin. Please go ahead.

Thank you, Emily. Welcome and good morning to everyone who called in or those who may listen later. This is Jeff Dool, CEO of Heritage Financial. Attending with me are Brian McDonald, President and CFO, CEO of Heritage Bank, and Jeff Dool, CEO of Heritage Financial. I'm Brian McDonald, President and CFO of Heritage Bank, Don Hinson, Chief Financial Officer, and Tony Shelfant, Chief Credit Officer. Our third quarter 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 third quarter investor presentation on the investor relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity, and credit quality. We will reference this presentation during the call. Please refer to the forward looking statements in the press release. We're really pleased with our operating results for the third quarter, including strong loan growth, deposit growth, margin expansion, and the continued benefits from our expense management efforts. The increases in average earning assets and net interest margin resulted in improvement in that interest income. We are optimistic the combination of core balance sheet growth and prudent risk management will continue to benefit our clients in the future. We are also optimistic that the financial results will continue to benefit our core profitability. We will now move to Don, who will take a few minutes to cover our financial results.

Thank you, Jeff. I'll be reviewing some of the main drivers of our performance for Q3 as I walk through our financial results. Unless otherwise noted, all the prior period comparisons will be with the second quarter of 2024. Starting with the balance sheet, loan growth was strong again in Q3, with loan balances increasing $147 million for the quarter. Yields in the loan portfolio were 5.60%, which was 8 basis points higher than Q2. Brian McDonald will have an update on loan production and yields in a few minutes. We are very pleased that we also had a strong quarter for deposit growth. Total deposits increased $193 million for the quarter. The second quarter was $137 million, of which about $83 million was in non-interest bearing deposits. Although there continues to be a change in the mix of interest bearing deposits from non-maturity deposit balances to CDs, it is occurring at a much slower pace. The percentage of CDs to total deposits only increased to .5% from 16% at the end of Q2. This is net of lowering our brokered CD balances by $10 million during the quarter. It is noteworthy that in Q4 we have $420 million of CDs maturing at an average cost of 4.56%. This represents almost half of our total CD balances, which we are expecting to reprice lower due to the decline in market rates. Due to the normal lag effect in the movement of non-maturity deposit costs after a Fed rate cut, we are not expecting the cost of these deposits to decrease. The rate of interest bearing deposits has not decreased much in Q4, as there continues to be strong competition for deposit dollars. Our cost of interest bearing deposits was .02% for Q3 compared to .03% for the month of September. The spot rate for interest bearing deposits as of September 30 was 2.04%. Investment balances decreased $86 million, mostly due to a loss trade executed during the quarter. A loss of $6.9 million was the result of a loss of $1.5 million in Q3. The loss of $6.9 million was recognized in the sale of 71 million of securities. These sales were part of our strategic repositioning of our balance sheet, and proceeds from the sales were used for other balance sheet initiatives, such as the funding of higher yielding loans. It is estimated that the annual pre-tax income improvement from the loss trade is approximately $3 million, resulting in an earn-back period of about two years. In addition to providing funds for loan growth, a combination of investment sales and deposit growth also allowed us to pay down barrings by $118 million in Q3. Of the remaining balance of $382 million at the end of the quarter, $64 million are overnight barrings, and another $148 million mature later in Q4. Moving on to the income statement, net interest income increased $1.8 million, which is .6% or 14% on an annualized basis. This improvement from the prior quarter was due to increases in both average earning assets and net interest margin. The net interest margin increased to .33% for Q3 from .29% in the prior quarter, due to a combination of increased loan yields and reduced balances in higher costing borrowings, partially offset by an increase in the cost deposits. Please see page 27 of our investor presentation for more information on net interest income and net interest margin. We recognize the provision for credit losses in the amount of $2.4 million during Q3, which is an increase from $1.3 million in the prior quarter. The provision expense was due to a combination of loan growth and a larger charge-off recognized in Q3. Tony will have additional information on this charge-off in editor quality control and control of the Q3. We will also discuss the financial control credit quality metrics in a few moments. Non-interest expense increased slightly from the prior quarter, but was $1.7 million lower than Q3 2023 levels. We continue to tightly manage FTE levels and other expenses in order to lower our overhead ratio, which decreased to .18% from .21% in the prior quarter and .25% in Q3 2023. And finally, moving on to capital, all of our regulatory capital ratios remain comfortably above low capitalized thresholds and our TCE ratio was .1% up from .9% in the prior quarter. Our strong capital ratios have allowed us to be active in lost trades on investments and in stock buybacks. During Q3, we repurchased 347,000 shares or approximately 1% of outstanding shares as part of our stock repurchase program at a weighted average cost of 2140 or 116% of September 30, a tangible book value per share. We have 1.16 million shares available for repurchase under the current repurchase plan as of the end of Q3. I will now pass the call to Tony who will have an update on our credit quality.

Thank you, Don. During the quarter, we experienced total charge-offs of just under 2.7 million with a majority tied to one owner-occupied CRE loan. The owner-occupant has ceased business operations and the final repayment of this loan will be dependent on the sale of the real estate collateral. It is worth noting that this loan was a known problem and has been actively managed by our special assets team since December of 2022. Modest recoveries of 112,000 led to net charge-offs of just over 2.5 million during the quarter. Through the first nine months of the year, we had just under 2.5 million in net charge-offs representing .05% of total loans, which is very much in line with historical norms. By comparison, our average annual net charge-offs for the three-year period 2018 through 2020 represented just over .07% of average total loans. Non-accrual loans totaled 4.3 million and we do not hold any OREO. This represents .09% of total loans and compares to .08% at the end of the second quarter. Overall, non-accrual loans increased by $475,000 during the quarter. Most of the increase came from the previously mentioned owner-occupied CRE loan. This loan was placed on non-accrual status during the quarter and then partially charged off near quarter end. This increase was largely offset by the receipt of SBA guarantee funds on a different loan that fully repaid the outstanding balance of just over 1.6 million. Page 18 of the investor presentation reflects the stability in our non-accrual loans over the past two plus years. Our non-performing loan totals increased modestly during the quarter, primarily due to our loans past two more than 90 days and still accruing. The majority of the 5.3 million in balances is attributed to one classified CNI relationship that is being actively...

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