Heritage Financial Corporation (NASDAQ:HFWA) Q3 2023 Earnings Call Transcript

Heritage Financial Corporation (NASDAQ:HFWA) Q3 2023 Earnings Call Transcript October 19, 2023

Heritage Financial Corporation beats earnings expectations. Reported EPS is $0.51, expectations were $0.44.

Operator: Thank you all for joining. I would like to welcome you all to the Heritage Financial Corporation Q3 2023 Earnings Conference Call. My name is Brika, and I’ll be your moderator for today’s call. All lines are on mute for the presentation portion of the call, with an opportunity for questions-and-answers at the end. [Operator Instructions] I would now like to pass the conference over to your host, Jeff Deuel, CEO of Heritage Financial to begin. So Jeff, please go ahead.

Jeffrey Deuel: Thank you, Brika. Welcome, and good morning to everyone who called in. And for those who may listen later, this is Jeff Deuel, CEO of Heritage Financial. Attending with me are Bryan McDonald, President and Chief Operating Officer; Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer. Our third quarter earnings release went out this morning premarket, 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 the presentation during the call.

Please refer to the forward-looking statements in the press release. We’re pleased to report another solid quarter with earnings per share exceeding consensus. This quarter’s performance was enhanced by loan recoveries. These recoveries are further evidence of our strong risk management practices and how they continue to benefit us. We continue to see pressure on deposit pricing in Q3, which is impacting our net interest margin. Deposit balances stabilized in Q3, although the mix of deposits continue to partially shift into higher rate products. As expected, due mostly to the rate environment, loan growth slowed in Q3 compared to the first two quarters of the year, although year-to-date, we are still reporting low single-digit loan growth. Overall, we continue to focus on growing a strong balance sheet with ample liquidity and capital that, will serve us well in the present and in the future.

We will now move to Don, who will take a few minutes to cover our financial results.

Donald Hinson: Thank you, Jeff. 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 of the prior period comparisons will be with the second quarter of 2023. Starting with the balance sheet. Loan growth slowed in Q3, increasing $15.5 million for the quarter. Year-to-date loan growth through Q3 is at 5.3%. Yields on the loan portfolio were 5.30% for the quarter, which was 11 basis points higher than Q2 and contributed to a 12 basis point increase in yield earning assets. Bryan McDonald will have an update on loan production and yields in a few minutes. Unlike the declines over the past few quarters. Total deposits increased $39.6 million during the quarter, the increase is due substantially to higher CD balances, as customers continue to take advantage of the higher rate environment by lowering their excess balances and lower paying non-maturity deposit accounts.

These factors contributed to an increase of 31 basis points in our cost of interest-bearing deposits to 1.23% for Q3. Also impacting total deposit balances in Q3 was the sale of our Ellensburg branch along with its $14.7 million of deposits as well as an increase of $62.8 million in brokered CDs during the quarter. Due to the current market pressure related to deposit rates, we expect to continue to experience an increase in the cost of our core deposits, although at a slower pace. This is illustrated by the cost of our interest-bearing deposits being 1.35% for the month of September with a spot rate of 1.38% as of September 30. Investment balances decreased $136 million during Q3 due to higher-than-normal maturities and prepayments during the quarter, as well as the sale of $47 million of securities.

These sales in combination with the purchase of $23 million of higher earnings securities, was done to partially restructure the portfolio while also increasing our cash position. A loss of $1.9 million was recognized on these sales in Q3, most of which occurred in September. It is estimated that the annualized income improvement, from these transactions will be $1.4 million, resulting in an earn-back period of 1.4 years. We will consider additional loss trades in order to continue, to defend our margin from downward pressures. Moving on to the income statement. Net interest income decreased $206,000 due to a decrease in net interest margin, partially offset by an increase in average earning assets. The NIM decreased to 3.47% for Q3 from 3.56% in the prior quarter.

The decrease in NIM was primarily due to the cost of interest-bearing deposits, increasing more rapidly than the yields on earning assets. We expect NIM to decrease further in Q4 since the NIM for the month of September was five basis points lower than it was for the quarter. The pace and duration of our decrease in margin will be highly dependent on continued increases in our cost of interest-bearing deposits, as well as maintaining deposit balances. As our cost deposits as well as deposit balances level off, we expect to experience margin stabilization due to the repricing of adjustable rate loans in addition to higher origination rates on new loans. We recognized a reversal of provision for credit losses in the amount of $878,000 during Q3 versus a provision expense of $1.9 million in Q2.

The reversal of provision expense was due to net recoveries of $1.2 million recognized during the quarter. Tony will provide more information on these recoveries in a few minutes. Non-interest income decreased $1 million from the prior quarter, primarily due to the loss on the sale of securities previously mentioned, partially offset by a gain of $610,000 on the sale of our Ellensburg branch that I discussed earlier. Non-interest expense decreased to $355,000 to approximately $41 million in Q3. This was due to decreases in numerous categories, partially offset by an increase in compensation and benefits. Compensation expense was higher compared to Q2 due to the adjustments we’ve made to the accrual for incentive-based compensation in Q2. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds and our TCE ratio is at 8.2%, down slightly from the prior quarter due primarily to AOCI.

In addition, with a loan deposit ratio of approximately 76% and cash balances over $200 million, we have plenty of liquidity to keep – to grow our loan portfolio. I will now pass the call to Tony, who will have an update on our credit quality metrics.

Anthony Chalfant: Thank you, Don. I’m pleased to report that credit quality remained strong and stable through, the first nine months of the year. As of quarter end, nonaccrual loans totaled just over $3 million, and we did not hold any OREO. This represents 0.07% of total loans as, compared to 0.11% at the end of the second quarter. Nonaccrual loans declined by $1.6 million, during the quarter and are now down by 51% over the last 12 months. Reductions of just over $2 million were largely tied to the payoff of an agricultural loan that, was the culmination of a long-term workout. Partially offsetting the reduction was the movement of three C&I relationships, to nonaccrual status in the aggregate amount of $440,000. Page 25 of the investor presentation reflects the significant improvement, we’ve experienced in our nonaccrual loans since the end of 2020.

This quarter, we began including loans over 90 days past due and still accruing interest in our nonperforming assets total. This total includes three loans that are well secured by commercial real estate, at low loan-to-value ratios and are in the process of collection. They remain on accrual status, because the risk of loss is very low. Criticized loans, those risk-weighted special mention and substandard totaled just under $135 million at the end of the quarter. This is a decrease of $8.5 million or 6% from the end of the second quarter. Criticized loans are virtually unchanged since the end of 2022. Within that group, loans rated substandard remained stable and are actually down by $3 million over that same time period. Overall, our commercial real estate portfolio continues to perform well and has been stable, through the first nine months of the year.

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Total criticized CRE loans represent 3.1% of our total CRE portfolio and 2.2%, of our entire loan portfolio. While we continue to closely watch our portfolio of office loans, we have yet to see any material deterioration in credit quality. At quarter end, criticized office loans totaled approximately $21.5 million which is down from the $25 million reported at the end of the second quarter. This represents 3.8% of our total portfolio of owner and nonowner-occupied office loans. In summary, we believe our office CRE portfolio is conservatively underwritten very granular and not materially exposed to the high risk of the central business district areas. Page 24 of the investor presentation provides more detailed information about our office loan portfolio.

During the third quarter, we had a large recovery on the payoff of the agricultural loan that I mentioned earlier. This represented the majority of the $1.3 million in total recoveries and was partially offset, by charge-offs of $138,000, resulting in a net recovery of just under $1.2 million for the quarter. Through the first nine months of the year, we’re in a net recovery position of $895,000. On Page 27 of the investor presentation, is a new slide that we believe demonstrates that by proactively identifying criticized assets within our portfolio, we’ve been able to keep our net charge-off levels lower than our peers. While our credit metrics remain strong, we remain watchful of inflation pressures and other potential weaknesses in the broader economic environment.

We are confident that our consistent and disciplined approach, to credit underwriting will continue to serve us well, should the economy show any material deterioration in the coming quarters. I’ll now turn the call over to Bryan for an update on loan production.

Bryan McDonald: Thanks, Tony. I’m going to provide detail on our third quarter loan production results, starting with our commercial lending group. For the quarter, our commercial teams closed $217 million in new loan commitments, up from $212 million last quarter and down from $277 million closed in the third quarter of 2022. Please refer to Page 19 in the third quarter investor presentation for additional detail on new originated loans over the past five quarters. The commercial loan pipeline ended the third quarter at $291 million, down from $473 million last quarter and down from $604 million at the end of the third quarter of 2022. Our heavy filtering of nonowner-occupied real estate loan request since March is the primary driver of the pipeline decline, although loan demand has also been softening as interest rates have moved higher.

Loan growth was below last quarter at $15 million despite the higher volume of new loans originated, due to a combination of higher prepays and payoffs, lower net advances on loans and lower principal balance on loans originated in the quarter. Please see Slides 20 and 21 on the investor deck for further detail on the change in loans during the quarter. Based on our lower pipeline levels and the softening loan demand, we anticipate our organic loan growth rate, to be in the low single-digits over the next couple of quarters and largely driven by prepay levels and advances on construction loans. The deposit pipeline ended the quarter at $134 million, up from $118 million last quarter and balances associated with new deposit accounts, opened during the quarter totaled $39 million.

The increase in the deposit pipeline is broad-based across the footprint, although we are seeing a higher concentration of new accounts coming from our new teams and the most disrupted markets. The Oregon and Portland MSA is the only major market where we saw net deposit growth during the quarter, with details reflected on Slide 10 of the investor presentation. Moving to interest rates. Our average third quarter interest rate for new commercial loans was 6.45%, which is 29 basis points higher than the 6.16% average for last quarter. In addition, the average third quarter rate for all new loans was 6.54%, up 27 basis points from 6.27% last quarter. The increase is due to a combination of higher underlying index rates and widening spreads implemented in 2023, versus working through the pipeline coming into the year that included pricing committed at lower levels.

The market continues to be competitive, particularly for C&I relationships. The mortgage department closed $18 million in new loans in the third quarter of 2023, compared to $25 million closed in the second quarter of 2023 and $26 million in the third quarter of 2022. The mortgage loan pipeline ended the quarter at $10 million versus $13 million last quarter and $18 million at the end of the third quarter of 2022. With mortgage rates remaining at higher levels, we anticipate volumes will continue at the relatively low levels we have seen year-to-date. I’ll now turn the call back to Jeff.

Jeffrey Deuel: Thank you, Bryan. As I mentioned earlier, we’re pleased with our performance in the third quarter. While we continue to experience the challenges of this rate environment and our deposit franchise, we are confident that the strength of our franchise will continue to benefit us over the long-term. Our relatively low loan-to-deposit ratio positions us well to continue to support our existing customers, as well as pursuing new high-quality relationships. And we will continue to focus on expense management and improving efficiencies, within the organization. Overall, we believe we are well positioned to navigate the challenges ahead and to take advantage, of any potential dislocation in our markets that may occur. That’s the conclusion of our prepared comments. So Brika, we’re ready to open the call to any questions callers may have.

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Q&A Session

Operator: Thank you. [Operator Instructions] The first question we have on the phone line comes from Matthew Clark of Piper Sandler. You may proceed with your question, Matthew.

Matthew Clark: Thanks. Good morning, gentlemen. First one from me, just on the securities sold in the quarter, can you give us a sense for the timing of that sale and the yield pickup that you anticipate, from reinvesting those proceeds? And then as a follow-up to that, just your appetite to do more?

Donald Hinson: So Matthew, we did it in September. So, we didn’t really get much benefit of it in Q3. The overall – an estimated, again, we purchased some securities, about $23 million, at $566,000. The rest went into cash and of course that’s earning about $540,000 of the $45 million that we sold. The average estimated pickup on the – annualized is $1.4 million or you might think of $350,000 per quarter on that. So, if you calculate that, that’s about a NIM pickup of about two basis points.

Matthew Clark: Yes. Okay. Thank you.

Donald Hinson: And we – are considering doing more, we’re going to watch the market and be selective. We did it. We could do this again. We could do more also depending on how we’re feeling about where the market is at.

Matthew Clark: Okay. And the yield on the securities sold, I can back into it, but just to make it easy on us?

Donald Hinson: $246,000.

Matthew Clark: Okay. Thank you. And then shifting gears to deposits. It looks like deposits were up in the region where you hire the bankers last year. Just – can you give us an update on that front? I assume none of that’s brokered related? Is it all core? And then, again, maybe an update on what you’re seeing in that Portland market with First Republic – that First Republic branch that’s closed?

Bryan McDonald: Sure. Matthew, it’s Bryan. And you see it on Slide 10, the deposits were up about $73 million since the start of the year. So that’s about a 13% growth rate versus the bank wide, we’re down about 9%. And if you look at the chart above on Slide 10 and the Seattle MSA, we’re actually down a little bit more 15%, just due to the amount of excess deposits – some of our customers had in that market. So, we are seeing disruption, we’re seeing benefit from – benefit as you’re seeing here. And it’s not just from the new team, we’re also seeing it positively benefit, on our other branches and other commercial teams in the market. And then the outlook is pretty favorable as well. I mentioned the pipeline numbers in my comments.

And a significant portion of both the loan and deposit pipelines, are coming from our new teams. It’s about 38% of the loan pipeline and then it’s actually a little over 40% of the deposit pipeline. So, we’re pleased with the outlook as well as the performance, and we are seeing disruption in that market from, as you mentioned, First Republic and the Columbia and Umpqua combo. And I’d also add, which I’ve said before, really the customers are coming from a variety of different spots, having the sales force down there without a portfolio out calling. Obviously, we’re getting a lot of strong opportunities. Again, not just the new team, but all of our teams and bankers in that market.

Matthew Clark: Okay. Great. And shifting to expenses, Don. You have an updated outlook on the run rate of non-interest expense is a little bit lighter than your low $42 million guide coming out of last quarter. I’m just curious, what your thoughts are on for 4Q?