Heritage Financial Corporation

Hello everyone and a warm welcome to the Heritage Financial 2025 Q3 earnings call. My name is Emily and I'll be moderating your call today. After the prepared remarks, you'll have the opportunity to ask any questions, which you can do so by pressing start followed by the number one on your telephone keypad. I would now like to turn the call over to Brian McDonald, President and Chief Executive Officer to begin. Please go ahead.

Thank you, Emily. Welcome and good morning to everyone who called in and those who may listen later. This is Brian McDonald, CEO of Heritage Financial. Attending with me are Don Hinson, Chief Financial Officer, and Tony Shelfont, Chief Credit Officer. A third quarter earnings release went out this morning pre-market, and hopefully you have had the opportunity to review it prior to the call. In addition to the earnings release, we have also posted an updated third quarter investor presentation on the investor relations portion of our website, which includes more detail on our deposits, loan portfolio, liquidity, and credit quality. We will reference this presentation during the call. As a reminder, during this call, we may make forward-looking statements, which are subject to economic and other factors. Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within the earnings release and the investor presentation. Improving net interest margin and tight controls on non-interest expense growth continue to incrementally drive earnings higher in the third quarter. On an adjusted basis, earnings per share was up 5.7% versus last quarter, and up 24.4% versus the third quarter of 2024. And on the same adjusted basis, our ROA improved to 1.11% versus 0.87% in the third quarter of 2024. We are excited about the pending merger with Olympic Bancorp. Their addition to the heritage franchise will add to the profitability of our operations and better position our company for growth in the Puget Sound market. We'll now move to Don 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 Q3. As I walk through our financial results, unless otherwise noted, all the prior period comparisons will be with the second quarter of 2025. Starting with the balance sheet, total loan balances are relatively flat in Q3, decreasing by 5.7 million. Although loan originations increased from Q2 levels, payoffs and prepayments also increased in Q3, while utilization rates decreased. Yields in the loan portfolio were 5.53%, which was three basis points higher than Q2. This was due primarily to new loans being originated at higher rates and adjustable rate loans repricing higher. Brian McDonnell will have an update on loan production and yields in a few minutes. Total deposits increased $73 million in Q3 and non-interest bearing deposits increased $33.7 million. The increase in total deposits was net of a $31.4 million decrease in certificate of deposit accounts, most of which was the result of a decrease of $25 million in brokered CDs. The cost of interest bearing deposits decreased to 1.89% from 1.94% in the prior quarter. As a result of the rate cut in September, we expect to see continued decreases in the cost of deposits. Investment balances decreased 33 million due primarily to expected principal cash flows on the portfolio. Due to the desire to preserve capital for the pending acquisition, we halted lost trade activity in Q3. We also did not purchase any securities in Q3. Moving on to the income statement, net interest income increased 2.4 million or 4.3% from the prior quarter due primarily to a higher net interest margin. The net interest margin increased to 3.64% from 3.51% in the prior quarter and from 3.30% in the third quarter of 2024. We recognize provision for credit losses in the amount of 1.8 million up from 956,000 in the prior quarter due primarily to an increase in the weighted average life of the construction loan portfolio. New construction loans increase the average life of the portfolio as well as reduce portfolio utilization rates. Net charge-outs remain at very low levels. Tony will have additional information on credit quality metrics in a few moments. Non-interest expense increased 530,000 from the prior quarter due mostly to increased comp and benefits expense as well as professional services. We recognized $635,000 of merger-related expenses in Q3, most of which was included in the professional services category. Comp and benefits expense was higher, primarily due to increased incentive compensation accrual. And finally, moving on to capital, all of our regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio was 9.8% up from 9.4% in the prior quarter. Similar to our inactivity in lost trades on investments, we were also inactive in stock buybacks in Q3 and are unlikely to resume stock buybacks this calendar year. I will now pass the call to Tony, who will have an update on our credit quality.

Thank you, Don. Through the first three quarters of the year, I'm pleased to report that credit quality remains strong and stable. Non-accrual loans totaled $17.6 million at quarter end, and we do not hold any OREO. This represents 0.37% of total loans and compares to 0.21% at the end of the second quarter. The largest addition during the quarter came from two loans totaling $6.7 million that are primarily secured by a townhome construction project. That project is nearly complete and the unit should be listed for sale before year end. There is currently no loss expected on these loans and the non-accrual decision was primarily tied to the delinquency status. Also within our non-accrual loan portfolio, we have just over 2.8 million in government guarantees. Non-performing loans increased modestly from 0.39% of total loans at the end of the second quarter to the current level of 0.44%. This increase was primarily tied to the previously mentioned increase to non-accrual loans. Criticized loans moved lower during the quarter. These loans rated special mention or substandard totaled just under $194.5 million at quarter end, declining by just over $19 million during the quarter. Substandard and special mention loans were down by 5% and 12% respectively during the quarter from a combination of payoffs and upgrades. At 2% of total loans, substandard loans remain at a manageable level and in line with our longer-term historical performance. Page 19 in our investor presentation provides more detail on the composition of our criticized loans and reflects the stability we've seen in this portfolio over the past two years. During the quarter, we experienced total charge-offs of $374,000 that were split evenly between consumer and commercial loans. The losses were partially offset by $256,000 in recoveries, leading to net charge-offs of $118,000 for the quarter. For the first nine months of the year, net charge-offs remain low at $911,000. 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 20 of the investor presentation shows our history of low credit losses and how we compare favorably to our peer groups. We are pleased with the strength and stability of our credit metrics for both the quarter and through the first nine months of the year. While we are closely watching the increase in our non-performing loans, it is important to note they remain at a low level when compared to our historical trends. While there has been some economic volatility this year, we have yet to see any material impact on our credit quality. We remain confident that our consistent and disciplined approach to credit underwriting will serve us well should the economy show any material deterioration in the coming quarters. 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 third quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $317 million in new loan commitments, up from $248 million last quarter, and up from $253 million closed in the third quarter of 2024. Please refer to page 13 in the investor presentation for additional detail on new originated loans over the past five quarters. The commercial loan pipeline ended the third quarter at $511 million, up from $473 million last quarter, and up modestly from $491 million at the end of the third quarter of 2024. As we look ahead to the fourth quarter, we are estimating new commercial team loan commitments of $320 million, which is very similar to Q3 levels. As anticipated, loan balances were fairly flat quarter over quarter with a $6 million decline in the quarter. Although total loan production was up $81 million, or 30%, versus last quarter, we continued to see elevated payoffs and prepaids, 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 124 million higher than last year, and net advances on loans have swung from a positive 142 million last year to a negative 75 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 fourth quarter, we expect loan balances to remain near Q3 levels, then resume growth to more normal levels in 2026 as loan payoffs moderate and the net advances move back to a positive position. Deposits increased $73 million during the quarter and are up $173 million year to date. The deposit pipeline ended the quarter at $149 million compared to $132 million in the second quarter. And average balances on new accounts open during the quarter are estimated at $40 million compared to $72 million in the second quarter. Moving to interest rates, our average third quarter interest rate for new commercial loans was 6.67%, which is up 12 basis points from the 6.55% average for last quarter. In addition, the third quarter rate for all new loans was 6.71%. up 13 basis points from 6.58% last quarter. In closing, as mentioned earlier, we are pleased with our solid performance in the third quarter. Deposit growth has allowed us to pay down borrowings and broker deposits while our loans have continued to reprice upward. These factors drove our net interest income up 2.4 million versus last quarter and 4.4 million versus the third quarter of 2024. The combination with Olympic Bank Corp and its subsidiary, Kitsap Bank, will add to this positive momentum in a significant way. We look forward to having the exceptional bankers at Kitsap join the Heritage Bank family and are excited about what we can accomplish together. Overall, we believe we are well-positioned to navigate what is ahead and to take advantage of 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. As a reminder, 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 today comes from Matthew Clark with Piper Sandler. Matthew, please go ahead.

Hey, Matthew. Hi. Hey, this is Adam Kroll. I'm for Matthew Clark and thank you for taking my questions.

Sure morning, Adam.

Yes. Yeah, so maybe just starting off on the margin. I was wondering if you had this spot cost of deposits September 30th and maybe the name for the month of September.

Sure, I've got a spot. Yes spot rate on cost deposits was The interest bearing was 187, and that was, of course, compared to 189 for the quarter. And for total cost deposit, it was 135. The NIM for September was 366 compared to 364 for the quarter.

Got it. That's super helpful. And then just on deposit costs, I guess, how much opportunity do you still see to reduce rates on the non-maturity side?

Well, we have close to, I think where it comes into play is mostly close, is approximately a billion we have in exception price that are costing us currently close to 3%. And so we will continue to, as rates are cut, to work those down. over time. It's a process and it doesn't happen all at once, but we have been working them down some. I will say also a lot of the new, if we bring on new accounts, though, they tend to be at the higher than the overall portfolio rate, so that mitigates some of the help of the rate cuts, but I do expect that we will continue to be able to work that down over time.

Got it. I appreciate the color there. And then maybe just one last one for me is I was wondering if you could just expand on how you're thinking about organic loan growth in 26 and do you have any visibility into payoffs and when they might normalize lower?

Sure, Adam. You know, we're, you know, expecting to move back to more of our traditional range, you know, mid to high single digits next year. On the second quarter call, I had mentioned anticipated growth hitting in the fourth quarter, and we have several additional larger payoffs we're now expecting here in the fourth quarter, so we're expecting to be flat again. So there's kind of two things going on. One is the cycling of some construction loans we've booked over the last few years that are reaching perm and paying off, and you can see that on on page 14 in the investor presentation just with the utilization rates on the construction loans. And so let's go to permanent payoff. And then a lot of the new bookings over the last couple quarters have been in that construction bucket, and so our fundings have been lower. If you look at the detail on the change in loans during the quarter, you can see our net advances on construction loans. or actually on all of our lines is, you know, is down this year versus up last year. So we expect, you know, as we get into 2026, work our way through the rest of these payoffs that we'll have, you know, positive net advances on those loans. So a bit of a tailwind versus the headwind that we had this year. And then the productions continue to be strong, you know, at over $300 million. this last quarter and expecting, again, $300 million in Q4, over $300 million in Q4. It's a little harder for me to see out into, you know, 2026 because our, you know, our pipeline is really accurate, you know, out 90 days. You know, it's hard to anticipate, you know, loan demand in 2026, although I would say things have been strengthening since the summer. And so based on that, I'm not seeing anything at this point that you know, would cause those, you know, cause loan demand to dip and, you know, the pipeline to shrink, you know, beyond all the obvious things that could drive that. We're seeing the trend move in the other direction right now.

Got it. Thanks for taking my questions.

Sure.

Thank you. Our next question comes from Jeff Rulis with Theo Davidson. Jeff, please go ahead. Thanks.

Thanks. Good morning. Maybe staying on the payoff front just to follow up. Any of that kind of managed by you or encouraged balance reductions for credit-related reasons?

Yeah, Jeff, I would say the kind of the change in the fourth quarter is some several larger payoffs you know, are for adversely classified, you know, credits. Not necessarily a circumstance where, you know, we're working them out of the bank, but ones where the customers have decided to, you know, sell the assets and pay it off. So that's the difference versus last quarter. We've got a few in that bucket and then one additional construction loan that's going to pay off in Q4. We're expecting Q4 Not a huge number of loans, but a couple of chunky ones in there.

Sure. No, that's helpful just to kind of get the whole picture on the edges. Maybe some of that activity is positive. I wanted to talk about the deposit success in the quarter. Pretty good core deposit growth. Is that a bit of seasonal factors in play, or is this just execution with the team, a bit of both? I was trying to see. unpack that a little bit.

Yeah, it is a bit of both. Third quarter, traditionally our strongest deposit growth quarter during the year, and that was the case last year, and we saw it this year. The years previously was hard to see it, of course, because, you know, all the rate changes and the outflow of excess deposits. But yes, seasonal increase, and then You know, we've had good additions from the new account activity side, and so those are driving the balances, as well as, you know, some accumulation in customer accounts, again, more related to that seasonality.

Got you. And then connected, maybe, Don, on the margin, I guess, you know, it sounds as if those deposit costs or spot rate and margin – trending well. Is there a bit of a carryover or a declining benefit from the lost trades? I guess anything you can put and take on margin, particularly in light of cuts as well, rate cuts, where would you sort of position the margin ahead?

Yeah, I don't think we're going to get the margin growth based off the rate cut we had in you know, mid September, which we didn't, you know, fill a full effect of or experience full effect of and kind of expecting one next week. I think we're going to continue to get again help on the deposit side. But I think the loan yields are going to be, you know, fairly flattish this quarter, we're going to continue to be able to reprice, you know, adjustable rate loans higher and new loans going on will be higher. But those rate cuts, you know, when we have, I think it's 22%, 23% fully floating, that also impacts it. So having a flattish loan yields for the quarter and maybe some help on the deposit side, I think we might continue to see some, you know, NIM improvement, but it'll be muted compared to last quarter.

Yeah. Okay. Thank you.

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

Hey, guys. Good morning. Thanks for the question. This is Liam on for David. Sure. So, you know, we've talked a lot about the deposit success in the quarter, and I was curious, you know, how has competition been trending in your markets, especially with a lot of banks targeting high levels of loan growth? where are you seeing the most opportunity for gathering those deposits, even in a seasonally stronger quarter?

Yeah, Liam, really it's the same strategy we've deployed in the past, you know, going after, you know, the operating relationships, you know, accounts that look for, you know, strong servicing. Don mentioned in his deposit comments that some of the new relationships we're bringing on have a little higher average cost than, you know, the bank's average, and that's because, you know, for those excess deposits, to the extent the customers are shopping, you know, between a few banks, you know, we're having to pay up on those excess deposits, maybe a little bit more so than we are within the portfolio on average. But then, of course, we're getting, you know, strong demand balances along the way. So we still see competition in our market, strong pricing competition on deposits. it's kind of varied from one local geography to another in terms of, you know, who the players are that are being particularly aggressive with deposits. So that continues to be a factor. But if you're going after the operating relationships, it's a different driver than price on that piece. So that's the key.

I appreciate that. Thank you. And, you know, on the acquisition of Olympics, How has progress in the pending deal been trending, and what are the most pressing priorities from your view post-deal approval and integration?

Yeah, everything is progressing, you know, right as planned. We have a project plan and timeline and everything is going smoothly. You know, not seeing anything at this point that would change. kind of our estimated closing date, beginning of Q1. We're on track for that. And then, of course, you know, coordinating closely with the Olympic team to make sure everything goes smoothly. And that's also been going very well. So nothing at this point of concern going just as we had anticipated.

Great. And then last one for me, asset quality remains pretty strong broadly, and it's great to hear that that credit migration is likely going to be resolved without loss in 4Q. With classifieds down quarter over quarter, is there anything you're watching more closely moving forward, or is all seemingly quiet?

Tony, I'll let you pick that one up. Yeah, Liam, good question. You know, I think what we're seeing is that the impact from some of the economic volatility has been sort of spotty through the portfolio, nothing really systemic. So, you know, we'll have – we have a few loans that were – or relationships that we're looking at, you know, that have been impacted somewhat by that. But generally speaking, it's just kind of the normal, you know, ins and outs of – into the classified criticized buckets that we typically see. So – No real particular trends we're watching. And as Brian mentioned, you know, we do have some positive momentum in the substandard category that may play out in the fourth quarter or should play out in the fourth quarter. And, you know, the loans that are in our non-performing bucket right now, we're just not seeing a lot of material loss potential there as of right now.

Thank you very much. I'll step back.

Thanks, Sam.

Thank you. Our next question comes from Jackson Laurent with Stevens. Please go ahead.

Hey, good morning. This is Jackson on for Andrew Terrell.

Good morning, Jackson.

If I could just hit on expenses first and apologize if I missed it. Adjusting for like the merger costs in the quarter expenses were right at the bottom end of like the previously guided 41 to $42 million expense guide. Just wondering if that's a good run rate that we should be looking for going forward.

Sure, I'll take that Brian. The one impact to this quarter that we haven't had is the state raised their revenue tax rate. And that's going to impact us by about $300,000 per quarter. So other than that, I expect it to be pretty similar. You know, we fluctuate some, right? Still would say, you know, the low 41s core and then we now we also have this 300,000 that we'll be dealing with. So it may bump up more into the mid 41s as a result. But that I think it still is a pretty good run rate overall. And we'll still have some acquisition-related costs, which I'm not sure exactly when they're all going to hit. We're going to have some, again, this quarter, but there will also be some, you know, next quarter and, of course, over the conversion post-acquisition.

Got it. That's helpful. Thank you. And then just last one for me. I know the primary focus has been on closing the current pending deal. integrating the franchise, but it seems like the M&A space has been heating up a little bit. Just wondering how you guys are thinking about M&A post-deal close and just honestly how conversations have been trending recently.

Yeah, obviously our first priority is to work through the transaction with Olympic and get that closed. We're anticipating early Q1 for the closure and We're continuing, you know, our discussions just like we always have. And, you know, if there was an opportunity that came up, we would consider it. So, you know, again, focus is on the, you know, Olympic deal and getting it closed. But looking ahead to next year, if the right opportunity came along, we'd certainly be open to taking a look.

got it uh that's all i had thank you for taking the questions okay thanks jackson thank you our next question comes from kelly motta with kbw please go ahead kelly hi this is charlie on for kelly mata morning charlie um i guess just kind of piggybacking on that last question just wondering how you're thinking about um capital from here you mentioned you're likely to pause the buybacks for the remainder of the year. Once the Kitsap deal is closed and integrated successfully, do you expect capital priorities to change in any meaningful way going forward as a combined bank?

Don, you want to comment on that one?

Sure. It's kind of hard to comment on this until we get through it and see exactly where we're coming out. Obviously, we modeled certain things. But we'll probably be preserving some capital as we're experiencing the transaction costs associated with it in addition to the upfront dilution. So we do expect to be earning quite a bit of capital back over time. But it's kind of hard to comment if we're going to be involved in any sort of buybacks at this point. It's not really a hard time commenting on that. We're just going to kind of wait and see. I wouldn't plan on needing your model at this point.

Understood. Thank you. And then in terms of how you're thinking about the loan-to-deposit ratio, it came down a bit this quarter, and I know you expect some liquidity from the Olympic deal. Just wondering high-level how you're thinking about managing that ratio moving forward.

Yeah, you know, high-level, we – you know, like to get it back, you know, up to 85 and, you know, would be comfortable, you know, a bit above that as well. So, you know, we're continuing to, you know, look for, you know, loan opportunities, you know, to deploy more of our assets into loans. So certainly our goal is to move it up to 85 and certainly be comfortable a bit higher than that.

Got it. Thanks for taking my questions. Thanks, Charlie.

Thank you. As a final reminder, if you would like to ask a question today, please do so now by pressing start, followed by the number one on your telephone keypad. With that, we have not received any further questions, and so we'll turn the call back over to Brian McDonald for any closing comments.

Thanks, Emily. 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, everyone, for joining us today. This concludes our call and you may now disconnect your lines.