Heritage Financial Corporation

everyone and a warm welcome to the Heritage Financial 2025 Q2 Earnings Call. My name is Emily and I'll be coordinating your call today. After the presentation you'll have the opportunity to ask any questions by pressing start followed by the number one on your telephone keypad. I would now like to hand the call over to our host Brian McDonald, President, to begin. Please go ahead.

Thank you Emily. Welcome and good morning to everyone who called in. For those who may listen later, this is Brian McDonald, CEO of Heritage Financial. Attending with me are John Henson, Chief Financial Officer, and Tony Chalfant, Chief Credit Officer. Our second quarter 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 second 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. Improving net interest margin and tight controls on non-interest expense growth continue to incrementally drive earnings higher in the second quarter. On an adjusted basis, earnings per share were up 8.2% versus last quarter and up 17.8% versus the second quarter of 2024. We are optimistic these trends will continue, and combined with prudent risk management, will provide progressively higher profitability as we finish out 2025. We will now move to John, who will take a few minutes to cover our financial results.

Thank you, Brian. I will be reviewing some of the main drivers of our performance for Q2. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the first quarter of 2025. Starting with the balance sheet, total loan balances increased $10 million in Q2 as loan originations increased from Q1, but payoffs and prepayments remain elevated. Yields on loan portfolios were 5.50%, which is five basis points higher than Q1. This was due primarily to new loans being originated at higher rates and adjustable rate loans repricing higher. Brian McDonald will have an update on loan production and yields in a few minutes. Total deposits decreased $60.9 million in Q2 due to the seasonal decline that occurred in April related to tax payments. However, average total deposits increased $35.4 million from the prior quarter. This marks the fifth consecutive quarter of us showing an increase in average total deposit balances. The cost of interest-bearing deposits increased to 1.94% from 1.92% in the prior quarter. Although we may see decreases in costs in certain deposit categories, such as CDs, we don't expect overall decreases in the cost of interest-bearing deposits absent further rate cuts by the Fed. Investment balances decreased 67.6 million, partially due to a loss trade executed during the quarter. A pre-tax loss of $6.9 million was recognized on the sale of $91.6 million of securities. These sales were part of a strategic repositioning of our balance sheet. A portion of the proceeds was reinvested in $56.4 million of securities, and the remaining proceeds were used for other balance sheet initiatives such as the funding of higher-yielding loans. Moving on to the income statement, net interest income increased $1.3 million. or 2.4% from the prior quarter due to a combination of a higher net interest margin and more days in Q2 compared to the prior quarter. The net interest margin increased to 3.51% from 3.44% in the prior quarter due primarily to increases in loan and investment portfolio yields. We recognize the provision for credit losses in the amount of $956,000 during the quarter due partially to loan growth and partially to net charge-offs. Tony will have additional information on credit quality metrics in a few moments. Non-interest expense decreased $298,000 from the prior quarter, due mostly to lower benefit costs and payroll taxes, as well as lower data processing vendor costs. These decreases were partially offset by higher professional services expense, which is partially related to achieving the lower vendor costs. We continue to guide in the $41 to $42 million range for quarterly non-interest expenses this year. And finally, moving on to capital, all of our regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio was 9.4% up from 9.3% in the prior quarter. Our strong capital ratios allow us to be active in lost trades on investments and stock buybacks. During Q2, we repurchased 193.7 thousand shares at a total cost of $4.5 million under our current share repurchase plan. We still have 797,000 shares available for repurchase under the current repurchase plan as of the end of Q2. I will now pass the call to Tony, who will have an update on our credit quality.

Thank you, Don. While we saw some modest deterioration during the quarter, the credit quality of our loan portfolio remains strong. Non-accrual loans total just under $9.9 million a quarter end, and we do not hold any OREO. This represents 0.21% of total loans and compares to 0.09% at the end of the first quarter and 0.08% at the end of 2024. The largest addition during the quarter was a $6 million multifamily construction loan. That project is nearly complete and is expected to begin leasing units in the third quarter. There is currently no loss expected on this loan, and the non-accrual decision was primarily tied to the delinquency status. Also contributing to the increase was a C&I loan that totaled $1.7 million when moved to non-accrual status. During the quarter, we charged this loan down to $1.3 million that is covered by the SBA guarantee. Including this loan, we have just over $2.3 million in government guarantees tied to this non-accrual loan portfolio. Page 18 of the investor presentation shows the low level of non-accrual loans we have experienced over the past three-plus years. Non-performing loans increased from 0.09% of total loans at the end of the first quarter to the current level of 0.39%. In addition to the previously mentioned increase in non-accrual loans, we have three loans totaling $8.6 million that are over 90 days past due and remain on accrual status. These loans are well secured and in the process of collection. While they are past their maturity date, they continue to make their monthly interest payments. All are expected to be either extended or paid in full during the third quarter. Criticized loans, those rated special mention and substandard, total just under $214 million at quarter end, increasing by $35.8 million during the quarter. Most of this increase was in the substandard category with several larger loan relationships downgraded from special mention during the quarter. The biggest driver of the increase is the $14.7 million non-owner-occupied CRE loan that is current, however, is currently not generating adequate cash flow to service staff. Also contributing to the increase was the downgrade of two related owner-occupied CRE loans where the owner-occupant is experiencing cash flow difficulties. At 2.1% of total loans, substandard loans remain at a manageable level and in line with our longer-term historical performance. During the quarter, we experienced total charge-offs of $558,000 that were largely tied to our commercial portfolio. The losses were offset by 64,000 in recoveries, leading to net charge-offs of 494,000 for the quarter. For the first six months of this year, we have had $793,000 in net charge-offs. This represents 0.03% of total loans on an annualized basis and compares favorably to the 0.06% we reported for the full year 2024. Page 21 of the investor presentation shows our history of low credit losses and how it compares favorably to our peer group. While we have some concern with the increase in non-performing and substandard loans this quarter, we believe it reflects a continued return to a more normalized credit environment after a period of unprecedented credit quality for the bank. We will continue to closely watch for areas of stress in the economy that could impact our credit quality. We remain consistent in our disciplined approach to credit underwriting and believe this is reflected in the solid level of credit performance we have maintained over a wide range of business cycles. I'll now turn the call over to Brian for an update on our production.

Thanks, Tony. I'm going to provide detail on our second quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $248 million in new loan commitments, up from $183 million last quarter, and up from $218 million closed in the second quarter of 2024. please refer to page 13 in the investor presentation for additional detail on new arranged native loans over the past five quarters. The commercial loan pipeline ended the second quarter at $473 million, up from $460 million last quarter, and down modestly from $480 million at the end of the second quarter of 2024. During the quarter, we continue to see tariffs and other uncertainty causing some of our customers to suspend capital plans. This is reflected in the pipeline that is relatively flat quarter over quarter versus showing a seasonal increase, which is what we saw last year and would be more typical. That being said, we are estimating third quarter commercial team new loan commitments of $300 million or 20% higher than the second quarter. Loan balances were up $10 million in the quarter after a decline of $37 million in the first quarter. Although production was up 65 million versus last quarter, we continue to see elevated payoffs and prepays. And similar to last quarter, the mix of loans closed during the quarter resulted in lower outstanding balances. Looking year over year, prepayments and payoffs are 59 million higher than last year. And net advances on loans have swung from a positive 106 million last year to a negative 26 million year to date in 2025. Please see slides 14 and 16 of the investor presentation for further detail on the change in loans during the quarter. Looking ahead to the third quarter, we expect loan balances to be relatively flat due to construction loan paydowns and payoffs increasing further. After the third quarter, we expect loan growth to resume as construction loan payoff activity returns to a normalized level. Deposits decreased during the quarter, but are up 100 million year to date. versus a decline of $82 million for the same period last year. A decline in deposits, similar to what we saw in 2024, is more typical of seasonal flows. The deposit pipeline ended the quarter at $132 million compared to $165 million in the first quarter, and average balances on new deposit accounts opened during the quarter are estimated at $72 million compared with $54 million in the first quarter. Moving to interest rates, Our average second quarter interest rate for new commercial loans was 6.55%, which is down 28 basis points from the 6.83% average for last quarter. In addition, the second quarter rate for all new loans was 6.58%, down 31 basis points from 6.89% last quarter. These average rates are based on outstanding loan balances. The drop in average rates is due to the funding mix of new loans during the quarter. and to a lesser extent, a 16 basis point decline in the five-year federal home loan index during the quarter. Using commitment amounts versus outstanding balances for all new loans closed during the quarter, the average rate was 6.80% versus 6.86% on commitment balances for the first quarter, or a decline of only six basis points. In closing, as mentioned earlier, we are pleased with our solid performance in the second quarter. Yields on loans and investment securities continue to increase, driving earnings higher versus the first quarter and the same quarter last year. We will continue to benefit from our solid risk management practices and our strong capital position as we move forward. Overall, we believe we are well positioned to navigate what is ahead and to take advantage of the various opportunities to continue to grow the bank. With that said, Emily, we can now open the line for questions from call attendees.

Thank you. We will now begin the question and answer session. If you would like to ask a question today, please do so now by pressing Start followed by the number 1 on your telephone keypad. If you change your mind or you feel like your question has already been answered, you can press Start followed by 2 to withdraw yourself from the queue. Our first question comes from Jeff Rulis with DA Davidson. Jeff, please go ahead.

Thanks. Good morning. Don, on the loss trade, do you have a projected earn back on that, on the timing, and then what the expected near-term margin impact would be or benefit?

Well, we have that on page – having to see on page six of our investor presentation, we have kind of that information for Q2. It's approximately a three-year earn back on the Q2 activity. In total, we've been doing about two years in total, but it was a little longer in Q2. But the pickup is estimated at about, I think, about $15,000, $5,000, I'm sorry, or $2.3 million pre-tax. So I don't have the exact yield pickup for you, but I guess you can figure that out with those numbers.

Okay. Okay. And I guess, John, we've talked in the past about sort of this maybe winding down on the restructures, but maybe just stepping back in the second half of the year to foresee much more of this activity.

As it always is for every quarter, it will depend on two things, what the market is going to give us and our needs for capital. You'll notice that some quarters are higher than others. We've always done a little something every quarter. We're always looking to improve the, you know, even though I think our investment portfolio is performance by hire and peers in general, we're always looking for ways to improve the overall performance. So, you know, I think that you might see something done, but a little off the pan. It could be very small to something we've done in the past, but probably not outside the range of what we've been doing over the last few quarters.

got it you mentioned the capital impact and maybe for Brian wanted to just check in on other forms of use on the buyback and if there's anything other strategic use of capital that considering your conversations on that front and maybe just I'll let Don take the buyback and then I'll pick up the other component of that so

You know, I think our stock price was advantageous in Q2. As you noticed, I don't think we did any Q1. So, again, that can fluctuate depending on our stock price and other needs. Also in Q1, we were monitoring some concentrations on our occupancy series loans. So, again, I haven't given you any definite guidance on what we're going to do in Q3, but... But we do have some left over, some still in our repurchase plan, and a lot will depend on the circumstances during the quarter.

And just picking up, Jeff, on the other uses from an organic standpoint, our loan production has actually really been strong. We had a couple hundred million in Q1, 267 in Q2. Q2 now, these are for the total bank, the numbers I mentioned in the script were just for commercial. And then we're projecting something over $300 million for next quarter. The mix hasn't had as much in the way of funding percentages as what we had last year, but the big change is payoffs, and in particular just a cycling of our construction portfolio we had. net advances last year that were really pretty significant in that category, and we re just seeing those cycle through. So, a long way of saying, at least if it relates to Q3, we re not expecting to need a lot of capital to support an oversized level of loan growth related to M&A and what's going on in the market. We're continuing to do what we've done in the past, remaining active and having conversations to the extent they're available just to stay in touch with other banks in the market. I think, as you know, in the Northwest, it's been predominantly credit unions that have been the acquirer here over the last couple of years. That's On that front, we certainly, you know, remain active in having the conversations, and if there was the right opportunity, if that was the right fit, we would pursue it. Same message, no change from the past there.

Thanks, Brian. Sorry, one more, maybe Tony. I just wanted to kind of get a sense on the credit side. Is there kind of moves in the quarter? Is that? or downgrade, does that reflect any added aggressiveness on your part or refresh credit review or is that more a sign of individual credits popping up and or kind of normalization type activities? Kind of from your end or macro is kind of the question.

Yeah, thanks, Jeff. Yeah, I'd say it's really just identified problem credits that have just been migrating down and it was just kind of happenstance that it was in the second quarter. We had a couple of two or three larger deals that had moved down the, you know, the risk rating curve. So I don't really think it's a real trend at this point. And as I mentioned in my comments, I think it's just, you know, more of the normalization that we've been seeing over the past few quarters on our classified and criticized credits. Again, it just so happened this quarter. It wasn't anything really more aggressive on our part. It was just circumstances.

Okay, thank you.

Thank you. Our next question comes from Matthew Clark with Piper Sandler. Please go ahead.

Hi, this is Adam Cole. I'm from Matthew Clark, and thank you for taking my questions. Sure. So, maybe to start, you have really strong growth in commitments and originations during the quarter. So I was just curious on where you see the largest opportunities for loan growth. And also you mentioned some pause among borrowers given the uncertainty on tariffs. So I would be curious on how that sentiment compares to April.

Sure. And I just in terms of the mix of loans that we're seeing, slide 13 in the investor presentation at the bottom has the breakout between the the categories, and it's really, you know, it's really CRE more so in the second quarter, and first quarter was pretty flat between the different categories. As we kind of finish out the year, see a little bit more commercial volume in the pipeline and owner-occupied, although some CRE in there as well. So maybe a little bit more balancing similar to CRE. you know, similar to the first quarter, although higher levels. And that's really pretty typical. You know, we're marketing for C&I and owner-occupied and then also doing some non-owner business at the same time. What was the second part of your question?

Just maybe how the sentiment among your borrowers has changed from what you mentioned.

Yeah, we're seeing, you know, as I mentioned, the pipeline remains strong. I think had it not been for the level of uncertainty in the market, we would see the pipeline up. above where it is now. So I guess the good news is we grew the pipeline quarter over quarter. We're down a little bit versus last year, but not much. You know, we're at 473 versus 480. You know, I would guess we'd be at, just for, you know, just for kind of reference, you know, 520, 530, 550 if it wasn't, you know, for kind of the tariff activity. So that gives you a sense, you know, maybe the pipeline's off somewhere around 5% to 10% of where it would be otherwise. And out in the offices with the bankers, you know, things are just moving a little slower in some of the offices with the customers. And then, you know, in other cases, we've got, you know, bankers with a, you know, a more full pipeline. So it's a little bit more intermittent than I think what we would see had we not had the disruption and some level of continued disruption in the markets.

Got it. I appreciate the cover there. I'm just switching to the margin. I was wondering if you had the spot rate on deposits June 30th and maybe a month of June.

Sure. The spot rate was 192 as of June 30th. And I believe our NIM was So, you can see that it continues to increase. So, it's a little higher on 31 just to be full disclosure there, but still seeing an upward growth on the NIM.

Right. And then, if I could squeeze in one more. I was just curious on the timing of when the investment in securities sale and reinvestment occurred during the quarter.

Most occurred in June.

Got it. Thanks for taking that question.

Thank you.

Thank you. Our next question comes from Kelly Mosser with KBW. Please go ahead.

Hi, this is Charlie. I'm for Taylor. Thanks for the question. I've had most of mine answered, but circling back to growth quickly, you've added some new teams recently. So I just wanted to make an update on kind of the ramp up there with production and if you think those relationships have been brought over, if those teams are still at the feet. And then a second part to that, if it's handled for further teamwork steps, if you're still looking for that. Thank you.

Sure. we expanded our the last two we expanded our um construction team this is you know one to four uh real estate um construction last this was summer of of 24 and um that team was you know fully staffed um here at the beginning of this year and our overall goal was to grow balances you know in that segment by about 75 million um You know, everything is going as planned, and we're pleased with the results. Maybe we'll lag a little bit versus what we were originally expecting, but that has more to do with some of the customer base slowing on some of their starts here earlier this summer. But expect that one to come in close. The other one was Spokane, which we announced in January, and based on the closings, And if the loan production office right now will be a full-service branch as we identify new space and main application. But really pleased with the results so far. Based on the loan closings and the commitments and what's in the pipeline, we already have a line of sight to the team hitting their year-end targets that we've set for them. So the holds are going well. And that kind of dovetails into your next question, which is, you know, new team lift outs, you know, with Spokane being on target. You know, we'd certainly be open to doing additional lift outs. We've been, you know, a little bit more limited last year and the year before, just trying to get our profitability back up. And so it's a balancing act. But we would certainly be open to, considering new teams that are always out in the market. Talking is just a matter of having, you know, making sure we have the right fit and feel like there's an avenue for us to hit the numbers.

Awesome. Thank you. And I guess just rounding out the margin conversation, I apologize if we already hit on this, but what do you kind of expect going forward with loan yields? Do you see those continuing to kind of like drift up X rate sets?

Yeah, good question. Go ahead, Don.

Yeah, we do this due to the repricing of, you know, just for rate loans and addition to any new loans going on at higher rates. So even with no rate cuts, you expect, you know, the five-year flood is, I mean, fairly stable. So that's where you price a lot of our real estate loans off of. And, of course, the prime rates haven't dropped, so... What is repricing is going up higher.

Charlie, I just add to that. Charlie, I just add to that. If you look at page 20 in the investor presentation, it has the repricing detail that Don just went through. So, you know, our average portfolio loan rate is 5.5, and you can see the repricing rates and the rates of the matured loans. And then the new rate on commitments during the second quarter, with 6.8% again versus the 5.5% average portfolio rate. So there is upward movement as we book new loans and get repricing.

Great. Thank you.

Thank you. Our next question comes from Liam Coohill with Raymond James. Please go ahead.

Hi, this is William. I'll say the future. Just actually following up on Charlie's question, it's been interesting to see low yields hold up so well, but also originating increased volume in 2-2 and looking at good growth moving forward. I'm curious to hear about the competitive environment in your market, and are you seeing any competitors potentially trying to fight on price to get deals done? Thank you.

Yeah, Liam, it's a good question. So the short answer is yes. I think the overall volume available in the market has gone down somewhat, and then, of course, that increases the competitive circumstances. So, you know, it's always in play for the categories that we go after, but with a little bit of volume declined, you know, we're certainly seeing that. In terms of the impact, you know, our overall pipeline is, you know, is holding up well. So we're still able to find deals to replace what we've closed. And then I would just say the new teams that we've added the last couple years, you know, that's kind of incremental volume, if you will, over what we would be doing otherwise. So that's also contributing to the increased pipeline. If we didn't have the new teams, you would see more of a dip in the pipeline versus what we're referencing. So hopefully that backstory helps.

I appreciate it. Thank you. And I'll be touching on what Adam's question mentioned, expanding the loan office in Spokane for a whole branch. I'm curious to hear what some of the best deposit growth potential in that market might be, as well as and customers do you think might be strong depositors in that branch? Thank you.

Yeah, good question. It's really more about the timing. We've always planned to open a full-service branch, and in the majority of the new expansion markets we've gone into, we're in an upper-floor office space, but want to have full deposit-taking capabilities to be able to you know, to bank the full relationships from the business clients that we bring in. So this is really just a matter of time. We moved into some temporary space and wanted to identify permanent space before staffing for a full branch. So, again, always plan just not at that stage. In terms of the, you know, the potential deposits, you know, The relationships that we're bringing in, we would expect, you know, full deposit relationships. Right now we're a loan production office, so we're somewhat limited. But kind of normal compensating balances, nothing particularly unique, you know, about Spokane, really driven off, you know, our ability to attract new clients.

Thank you. And last one for me. I know earlier you mentioned certain offices have been seeing more strength than others on the loan production side. And just curious to hear what dynamics have been driving that. Is it more stronger geographies in particular areas, different end market focuses, or has it been some of those new teams that have brought additional strength?

There's no specific pattern. The economy is actually really strong, you know, throughout the corridor, you know, on the, you know, west side of Washington up and down the I-5 corridor all the way, you know, south Eugene. It's strong. So it's just more intermittent what the customers of a particular office are doing or not doing. And then the only other couple comments I'd make, Our strongest markets are the King County MSA and then the Portland MSA, which King County MSA encompasses the counties to the north and the south. But that's because those are the largest markets that tend to make up the biggest portion of our pipeline. And then the other big driver is just where it's the most disruption in the market because we tend to get our new accounts where we have a disrupted marketplace where there's been you know, M&A activity or other changes at other institutions that might cause customers a little bit of a push away to consider coming to Heritage, particularly, you know, if we have somebody that's worked with them previously at a prior bank. So maybe a little bit heavily, a little bit more heavily weighted to some of the new teams, but at the same time, they don't have a portfolio, so they're out, you know, in the market, you know, fully calling with all their time. So anyway, hopefully that helps.

My three colors. Thank you so much. I'll step back.

Thank you. At this time, we have no further questions. I'll turn the call back over to Brian McDonald for closing remarks.

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

Thank you all for joining us today. This concludes our call and you may now disconnect your lines.