Heritage Financial Corporation (NASDAQ:HFWA) Q4 2022 Earnings Call Transcript

Heritage Financial Corporation (NASDAQ:HFWA) Q4 2022 Earnings Call Transcript January 26, 2023

Operator: Thank you for standing by and welcome to the Heritage Financial Corporation Q4 2022 Earnings Conference Call. My name is Sam, and I will 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. I would now like to hand the conference over to Jeff Deuel, CEO of Heritage. Jeff?

Jeffrey Deuel: Thank you, Sam. Welcome, and good morning to everyone who called in and those who may call in later. This is Jeff Deuel, CEO of Heritage Financial. Attending with me are Don Hinson, our Chief Financial Officer and Bryan McDonald, our President and Chief Operating Officer; Tony Chalfant, 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 are very pleased to report another solid quarter and year. We had good organic loan growth. We are 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 are 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 long-standing focus on credit quality and actively managing our loan 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 phase into a more difficult economic environment in 2023. We will now move on to Don who will take a few minutes to cover our financial results and credit quality metrics.

Donald Hinson: 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 of 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 improved 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 on our loan portfolio were 4.86% in Q4, which was 35 basis points higher than Q3. Bryan 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 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 a 130 basis point negative impact on the TCE ratio.

In addition, with a loan-to-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 31, non-accrual loans totaled $5.9 million, and we do not currently hold any OREO. This represents 0.15% of total loans and 0.08% 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 $320,000 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 31, criticized loans totaled $135 million or 3.3% of total loans. At year-end 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 year-end 2022, we saw very little deterioration in credit quality. Criticized office loans totaled 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.

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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 Bryan, who will have an update on loan production.

Bryan McDonald: Thanks, Don. I’m going to provide detail on our fourth quarter loan production results, starting with our commercial lending group. For the quarter, our commercial teams closed $329 million in new loan commitments, up from $277 million last quarter and the same as the $329 million closed in the fourth quarter of 2021. Please refer to Page 19 in the fourth quarter investor presentation for additional detail on new originated loans over the past five quarters. The commercial loan pipeline ended the fourth quarter at $536 million, down from $604 million last quarter, and up from $462 million at the end of the fourth quarter of 2021. The pipeline decline was due to the strong volume of loan closings during the fourth quarter and the moderating demand for loan opportunities we have been reporting in the last two quarters.

New commercial teams hired during 2022 have been adding to our loan pipeline and producing strong results as reflected on Slide 10 of the investor presentation. Loan balances in Eugene and the Portland MSAs increased 33% during 2022 and grew at a 54% annualized rate from June 30 through the end of 2022. The reported pipeline does not include any loan opportunities from our new team in Boise as this branch did not open until early January. I hope you have had a chance to read our January 10 press release where we announced our new Boise, Idaho branch. Loan growth was $50 million for the quarter or 5% annualized, which is below the growth rate we experienced earlier in the year. Although new loan production during the quarter was higher than any other quarter and we purchased a small residential mortgage pool, this was offset by a higher mix of unfunded construction loans and a decrease in the utilization rate, which led to a $20 million decline in net advances this quarter versus a $55 million increase last quarter.

Please refer to Slides 20 and 21 of the investor deck for further detail on the change in loans during this quarter. Consumer loan production, the majority of which are home equity lines of credit, was $21 million during the quarter, which is down from $29 million last quarter and $23 million of production in the fourth quarter of 2021. The mortgage department closed $18 million of new loans in the fourth quarter of 2022 compared to $26 million closed in the third quarter of 2022 and $45 million in the fourth quarter of 2021 with mortgage rates remaining at higher levels. We anticipate volumes will continue at the relatively low levels we saw in the second half of 2022. Moving to interest rates. Our average fourth quarter interest rate for new commercial loans was 5.72%, which is 85 basis points higher than the 4.87% average for last quarter.

In addition, the average fourth quarter rate for all new loans was 5.51%, up 62 points from 4.89% last quarter. Although the marketplace continues to be competitive, we are seeing a portion of the rate increases translate into higher quoted rates on new loans. I’ll now turn the call back to Jeff.

Jeffrey Deuel: Thank you, Bryan. As I mentioned earlier, we are pleased with our performance in the fourth quarter and for the full-year 2022. We are seeing solid organic production across the bank with deals coming from existing customers and new high-quality prospects. Additionally, we are seeing multiple new business opportunities coming from the new teams in the southern part of our footprint, and we expect the new Boise team to start contributing to the revenue line soon. Based on our current pipeline, we expect Q1 loan production to be in the mid single-digit range based on current deal flow. We will continue to focus on expense control with little or no increases in staffing in 2023 other than opportunistic hiring to strengthen our production teams.

We have also maintained a focus on our technology strategy, which is designed to support more efficient operations, enabling us to do more with the same people and provide a more consistent customer experience. This also positions us well to pivot as bank technology continues to evolve and we continue to grow. Please see Slides 6 and 7 of the investor deck for more detail on our tech strategy. We are prepared to pursue acquisitions in our three-state region when we see the right opportunities for us. In the meantime, we continue to focus on opportunities to add new teams like we have done in Oregon and Idaho, as well as add individual producers throughout the footprint. Please see Slide 13 in the investor deck for a historical look back of our M&A and team lift-out activities.

As Don mentioned earlier, our capital levels and our liquidity position provide us with a strong foundation to address unforeseen challenges and to take advantage of opportunities in the current environment. We are grateful to all of our employees for the constructive collaborative team environment we work in and for everyone’s hard work and focus as we’ve contributed to the €“ as that has contributed to the success of the bank in 2022. That is the conclusion of our prepared statement, Sam. So we are ready to open up the call for any questions that people may have.

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Q&A Session

Operator: Absolutely, Jeff. We will now begin the Q&A session. Our first question today comes from the line of Matthew Clark with Piper Sandler. Matthew, your line is now open.

Matthew Clark: Hey. Good morning, guys.

Jeffrey Deuel: Good morning.

Matthew Clark: Maybe just around the margin, trying to get some better visibility going into the first quarter here. The spot rate at the end of the year on interest-bearing deposits or total deposits and the average margin in the month of December, if you have it?

Donald Hinson: I’ll take that, Matthew. Our spot rate for interest-bearing deposits in December was 32 basis points, up a little bit from the overall average of 29 €“ or 25 for the quarter. And then also the margin for December was 406.

Matthew Clark: Okay. And that’s on a reported basis? I think it’s fairly similar to the core anyway?

Donald Hinson: Which one are you talking about, the NIM?

Matthew Clark: The margin €“ the December margin you just quoted, I assume that’s…

Donald Hinson: Yes, the same as we report quarterly.

Matthew Clark: Same as, yes, that’s what I thought. That’s right. Yes. Yes. Okay. Got it. And then maybe just on deposits, they were down in the quarter. I know some of it moved to the wealth management platform you guys have. But it sounds like there’s an expectation that deposits continue to decline here maybe in the next quarter or two. I would have thought some of those new bankers you brought over six, seven, eight months ago would have been able to mitigate some of those industry pressures. But I don’t know if rates are making it difficult for them to bring over prior relationships or not both on the loan and deposit side. Any color there?

Bryan McDonald: Jeff, do you want me to take that one?

Jeffrey Deuel: Well, sure, Bryan. Go ahead. I can add if I think of something I want to add to…

Bryan McDonald: Okay. Matthew, this is Bryan. I was just going to €“ if you look at Slide 10 in the deck, that’s where the bulk of the new team members fall into. And so you can see on the deposit side, we had a little bit of decline in that market. It went from $748 million deposits to $724 million, so a little bit of decline, but lower deposits than what we’ve seen elsewhere in the bank. So with overall deposits declining, just not seeing as much impact. And then, of course, on the loan side, I commented on that. We’ve had nice increases in loan balances. So those will come a little quicker than some of the deposit balances. But we’re seeing good activity across the footprint. Obviously, those teams are out calling and we’re just doing what we can as an institution to support them. But we are seeing good momentum on both the deposit and loan side.

Matthew Clark: Okay. And then just maybe for Don, on the non-interest expense run rate, pretty much in line with the guidance you gave, maybe on the higher end, but what are your kind of updated thoughts on the run rate coming into the new year and how it might transition or progress through the year?

Donald Hinson: Yes. I think it’s going to increase. We’ve got a couple of factors here. Again, we added Boise right at the €“ basically year-end. We’ve had a lot of costs in Q4, and we will have costs as we develop that office. In addition, the FDIC premiums are going up this year, and that’s going to be about $1 million for the year, and so it’s about €“ if you average that out about 250 per quarter. So I think it’s going to be in the $41 million to $42 million range per quarter as a result . In addition to overall continue some inflationary pressures that we’re feeling. But overall, I think that we’re going to end up.

Matthew Clark: Okay. Thank you.

Operator: Thank you, Mr. Clark. The next question is from the line of Eric Spector with Raymond James. Eric, your line is now open.

Eric Spector: Hey, everybody. This is Eric on line for Dave Feaster. Congrats on a solid quarter, and appreciate you taking the question. Just wondering how you think about liquidity here and potential outflows. Cash is down to around 1% of assets. We continue to see outflows. How would you look to €“ would you look towards borrowing or potentially sell securities? How do you kind of handle defending your deposit base? Any color on there would be great.

Jeffrey Deuel: Yes. Don, do you want to take that?