Title

Presentation

Heritage Financial Corporation beats earnings expectations. Reported EPS is $0.51, expectations were $0.45.

Operator: Hello, everyone, and a warm welcome to Heritage Financial Q4 and Year-End Earnings Call. My name is Emily, and I’ll be coordinating your call today. [Operator Instructions]. I will now turn the call over to Jeff Deuel, CEO, to begin. Please go ahead.

Jeff Deuel: Thank you, Emily. Welcome and good morning to everyone who called in and those who may listen later. This is Jeff Deuel, CEO of Heritage Financial. Attending with me are Bryan McDonald, CEO of Heritage Bank, and Tony Chalfant, Chief Credit Officer. Don Hinson, CFO, is unable to join us today because he’s under the weather. So we have asked Jennifer Nino, our Chief Accounting Officer, to participate in his place. As many of you know, we announced CEO transition, excuse me, succession in July of 2024. That plan has been underway for some time now with the goal of providing a smooth transition for everyone, including employees, customers, shareholders, investors, and the communities we serve. I will continue as CEO of the holding company until May 5, 2025, when I will retire and become a non-executive advisor to the bank.

At that time, it is expected that Bryan McDonald will add CEO of the holding company to his current title as CEO of the bank. To that end, I would like to turn the call over to Bryan.

Bryan McDonald: Thank you, Jeff. Our fourth quarter earnings release went out this morning pre-market, and hopefully you have had the opportunity to review it prior to the call. We have also posted an updated fourth quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity, and credit quality. We will reference this presentation during the call. Please refer to the forward-looking statements in the press release. We are very pleased with our operating results for the fourth quarter, including strong loan growth, margin expansion, and the continued benefits from our expense management efforts. We are optimistic the combination of core balance sheet growth and prudent risk management will continue to benefit our core profitability as we progress through 2025. We will now move to Jennifer, who will take a few minutes to cover our financial results.

Jennifer Nino: Thank you, Bryan. I will be reviewing some of the main drivers of our performance for Q4. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the third quarter of 2024. Starting with the balance sheet, loan growth was strong again in Q4, with loan balances increasing $123 million for the quarter. Yields on the loan portfolio were 5.53%, which was seven basis points lower than Q3. This was due primarily to the 100-basis point reduction in the Fed funds rate from September through December. Bryan McDonald will have an update on loan production and yields in a few minutes. After strong growth in Q3, deposits were relatively flat in Q4. Total deposits decreased $24 million in the quarter due to a $25 million reduction in brokered CDs. Much like the past several quarters, we continue to experience our strongest growth in our core CD balances as customers continue to seek the higher-yielding products.

Even with the growth in higher-costing CDs, the cost of interest-bearing deposits decreased to 1.98% in Q4 from 2.02% in the prior quarter. We expect to continue to see further quarterly decreases in the cost of deposits, as shown by the fact that our spot rate for the cost of interest-bearing deposits as of December 31 was 1.94%. Investment balances decreased $104.5 million, partially due to a loss trade executed during the quarter. A pre-tax loss of $3.9 million was recognized on the sale of $36 million of securities. These sales were part of our strategic repositioning of our balance sheet and proceeds from the sales were used for other balance sheet initiatives, such as the funding of higher-yielding loans. It is estimated that the annualized pre-tax income improvement from this loss trade will be approximately $1.4 million, resulting in an earn-back period of about three years.

In addition to the loss trade on investments, during the fourth quarter, we executed on a partial restructuring of our BOLI portfolio. We surrendered $34 million of policies, which resulted in approximately $2.4 million in additional tax expense. We redeployed $19 million of the proceeds into new policies, yielding approximately 300 basis points higher than the policies we surrendered. We also initiated tax-free exchanges on approximately $10 million of BOLI policies. In addition to the related tax expense, we incurred other transaction costs of approximately $500,000 in Q4. These combined actions will generate cash for other balance sheet needs and improve the yield on the remaining BOLI portfolio. Moving on to the income statement, net interest income increased $805,000.

This improvement from the prior quarter was due to an increase in net interest margin. The net interest margin increased to 3.39% for Q4 from 3.33% in the prior quarter, due primarily to decreases in the cost of both deposits and borrowings. Please see page 27 of our investor presentation for more information on net interest income and net interest margin. We recognize the provision for credit losses in the amount of $1.2 million during the quarter. The provision expenses due primarily to loan growth, as net charge-offs were very minor for the quarter. Tony will have additional information on credit quality metrics in a few moments. Non-interest expense increased $250,000 in the prior quarter, due primarily to timing of marketing and professional services expenses, although we are still well below Q4 2023 levels.

We continue to tightly manage FTE levels and other expenses in order to maintain a lower than historical overhead ratio, which was 2.20% in Q4. And finally, moving on to capital, all of our regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio was 9.0%, down slightly from 9.1% in the prior quarter. Our strong capital ratios have allowed us to be active in lost trades on investments and in stock buybacks. During Q4, we repurchased 165,000 shares as part of our stock repurchase program at a total cost of $4.3 million. We have 990,000 shares available for repurchase under the current repurchase plan as of the end of Q4. I will now pass the call to Tony, who will have an update on our credit quality.

Tony Chalfant: Thank you, Jennifer. I’m pleased to report that credit quality remains strong and stable. Non-accrual loans totaled just over $4 million at year-end, and we do not hold any OREO. This represents 0.08% of total loans and compares to 0.09% at the end of the third quarter and 0.10% at the end of 2023. I would also note that adjusting for government guarantees, non-accrual loans would be $3.1 million. Overall, we saw a decline of $222,000 during the quarter. Page 18 of the investor presentation reflects the stability in our non-accrual loans over the past three years. Non-performing loans were 0.11% of total loans at year-end versus 0.21% at the end of the third quarter. The improvement came from a combination of one CRE loan that was paid in full and paydowns on several loans that are part of one classified C&I relationship.

Criticized loans, those rated special mention and substandard, total just over $179 million at year-end, rising by 4.7% during the quarter. Most of the increase was from the downgrade of three C&I relationships from pass to the special mentioned category. Loans in the more severe substandard category were down by 5% or $3.7 million during the quarter. Substandard loans represented 1.4% of total loans at year-end and compares favorably to the 1.6% we experienced at year-end 2022 and 2023. The credit quality of our office loan portfolio has remained stable over the last 12 months. This loan segment represents $566 million, our 12% of total loans, and is split evenly between owner and non-owner occupied properties. The average loan size is 1.1 million.

They are diversified by geographic location, and we have little exposure to the core downtown markets. Criticized office loans are limited to just under $15 million, representing 2.6% of total office loans. Page 17 of the investor presentation provides more detailed information about our office loan portfolio. During the quarter, we experienced total charge-offs of $96,000 that were primarily in our consumer portfolio. The losses were offset by $69,000 in recoveries, leading to net charge-offs of just $27,000 for the quarter. For the full year, we experienced net charge-offs of just over $2.5 million, or 0.06% of total loans. This compares to a net recovery of $277,000 for 2023. While 2024 was a strong year for credit quality, we did see a continued slow movement back to a more normalized credit environment.

While we will not be immune to isolated credit issues, we are confident that our consistent and disciplined approach to credit underwriting and portfolio management will continue to generate strong credit quality performance. 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 fourth quarter loan production results, starting with our commercial lending group. For the quarter, our commercial teams closed $316 million in new loan commitments, up 25% from the $253 million last quarter, and up 69% from the $187 million closed in the fourth quarter of 2023. 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 fourth quarter at $452 million, down from $491 million last quarter, and up from $329 million at the end of the fourth quarter of 2023. Loan growth for the fourth quarter was $123 million, or just over 10%, annualizing the quarterly results, and was 10.8% for the full year.

The growth in the quarter was driven by an increase in new production across the footprint, both from existing and new customers, and a continuation of moderate prepay and payoff levels. The growth during the year was due to improving loan demand, higher banker activity levels, and the new teams we added over the last few years. Excluding the results of the new teams, 2024 growth would have been 8.7% versus the 10.8% I just mentioned. Please see slides 14 and 16 of the investor presentation for further detail on the change in loans during the quarter. Focal date deposits declined $24 million during the quarter but were essentially flat after adjusting for the $25 million reduction in brokered CDs during the quarter. Average deposit balances during the fourth quarter were $30 million higher than the ending focal date balance, and we did see deposit balance variability with swings both ways during the period.

For the full year, deposits were up $85 million, primarily due to the contribution of the new teams. New business acquisition continued at the elevated levels we’ve been reporting all year. The deposit pipeline ended the quarter at $141 million, compared to $165 million last quarter, and the average balances on new deposit accounts opened during the quarter are estimated at $121 million, compared to $72 million in the third quarter. Moving on to interest rates, our average fourth quarter interest rate for new commercial loans was 6.63%, which is up 10 basis points from the 6.53% average for last quarter. Fixed rates on new business continued to move up during the fourth quarter, following the direction of the underlying federal home loan bank indexes, which more than offset the declines in variable rates on new loans tied to Prime and SOFR.

In addition, the fourth quarter rate for all new loans was 6.66%, up 7 basis points from 6.59% last quarter. As I mentioned earlier, we are pleased with our solid performance in the fourth quarter. It was another very strong quarter of loan growth and the second consecutive quarter of net interest margin improvement in increasing net interest income. 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 various opportunities to continue to grow the bank. With that said, Emily, we can now open the line for questions from the call attendees.

Operator: Thank you. [Operator Instructions]. Our first question today comes from Jeff Rulis with DA Davidson & Co. Please go ahead, Jeff.

Jeff Rulis: Just checking in on the margin and I guess either Jennifer or all, the first, you have the December margin average, and the second piece of the question is similar to last quarter, trying to get the real-time sort of benefit of the restructuring, assume that it was not captured in the fourth quarter and I guess expectations for the margin ahead.

Bryan McDonald: Sure. Thanks, Jeff. Jennifer, I will pass to you to answer that one.

Jennifer Nino: Okay. Thank you. Just for December, our margin, our core margin for December was 3.44%, so that is compared to a quarterly 3.39%. We do expect to see continued expansion in NIM, although it is going to be highly dependent on rates for deposits over the upcoming quarters, but definitely some expansion over the next several quarters.

Jeff Rulis: Okay. Jennifer, do you have the — go ahead.

Bryan McDonald: Sorry, Jeff. Go ahead. You go ahead.

Jeff Rulis: No, just trying to kind of carve out the expectation for expansion. Some of that is sort of preloaded with the restructure and then there is sort of the baseline expectation on a core basis where you are positioned, just trying to piece that out a little bit. I know that is granular, but helpful.

Bryan McDonald: Jennifer, maybe a comment on when during the quarter the restructure happened, if you have that information.

Jennifer Nino: Yes. We did it in the later half of the quarter, and so that would be impactful for more November, December timeline, so we will see some continued improvement in Q1 for our margin. We also expect on the borrowing side, our borrowing costs for the quarter were 5.02%. Our current spot rate for borrowings is about 4.7%, so we should see some continued reduction in borrowing costs as well. So, again, we will see some continued improvement in NIM. It will really just highly depend on balance sheet position and where our assets and liabilities are.

Jeff Rulis: Okay. That is great. Thank you. And maybe shifting to capital for Jeff or Bryan, you saw the dividend increase. You are active on the buyback. Want to get a sense for is that any less — you have seen really strong wins with teams. I do not know if those capital moves suggest that M&A is still out there, or maybe they are not exclusive of one another. Just checking in again on your priorities and opportunities out there.

Bryan McDonald: Sure. Sounds good, Jeff. I will cover the M&A and the teams and then have Jennifer comment on just the other capital priorities. M&A is really — the circumstance is really unchanged from last time we talked about it. Jeff and I are still active, and we, of course, have the slide 11 in the deck, the same slide. So, we are active in discussions, but really no change there. In terms of new teams, confident that we will do at least one additional team this year. We are very conscious of the expenses of adding a new team, but continue to be active in the market, recruiting for top talent, have had good success in growing in markets, and still see that as a high priority for us. Jennifer, pass to you for stock buybacks and lost trades.

Jennifer Nino: For stock buybacks, we consider ourselves to be in a very good capital position, so we will consider moderate levels of buybacks, but it will be dependent on factors such as stock price and other needs of capital. As noted earlier, we have about 990,000 shares outstanding, or an ability to repurchase about 990,000 additional shares. For the investment activity, we will consider additional lost trades if it makes sense at the time, and we found that the lost trades over the past several quarters have been very beneficial to us. We have picked up about over $17 million of additional income with approximately a two-year earn back period, and we do have more information on page 6 of our investor presentation that details out our quarterly lost trades. But again, we will consider doing that, but it will be highly dependent on the market at the time. Overall, our earn back period is going to be about — expected to be about three years.

Operator: The next question comes from David Feaster with Raymond James. Please go ahead, David.

Liam Coohill: Hi. This is Liam on for David. How are you guys today?

Bryan McDonald: Good. How are you?

Liam Coohill: Doing well, thank you. So, just following up on some of the loan commitments in the quarter, CRE and construction look like some of the key drivers. Can you talk about where you’re seeing some of the opportunities and where there might be more to come in 2025?

Bryan McDonald: Sure. And page 13 has a breakout of the new loan commitments on a quarterly basis, going back to Q4 of last year. So, Q1, Q2, Q3, it was C&I that drove the balances or drove the new commitments, which was what our focus has been, increasing the C&I volume for the benefit of the deposits. We did see a little higher CRE activity in the fourth quarter, and we have seen the number of new CRE opportunities pick up in terms of inbound inquiries. Our goal is to balance out the volume, and looking at what’s in the pipeline now, it’s probably closer to a 50-50 number between the C&I owner-occupied CRE as compared to the non-owner. But we are watching it closely and encouraging our teams to continue to focus additional attention on the C&I activity.

Liam Coohill: I appreciate that. Thank you. And moving to expenses, the expense control has been really impressive, and I appreciate the comments on managing FTEs. What are your thoughts on the expense run rate moving forward into 2025?

Bryan McDonald: Sure. Jennifer, I’ll pass it to you for that one.

Jennifer Nino: Okay. So, as you noted, we continue to closely monitor our FTE levels, and our goal is to maintain FTE at about the year-end 2024 level. However, we have some initiatives, including the already noted expansion of Builder Banking Business, which will add to our costs. We also have our annual merit increases and annual increases in vendor costs. So, we’re continuing to target the $41 million to $42 million range per quarter, as noted in our prior call last quarter.

Liam Coohill: Great. Thank you so much. And just one more. Where do you expect your effective tax rate to be in 2025?

Jennifer Nino: I can go ahead and answer that, Bryan. So, you’ll note in the fourth quarter that we did have a one-time cost for the BOLI restructure, which was about $2.4 million. Without that, we were about 12.5% effective tax rate for the quarter in the year. For 2025, we expect to be in about the 15% to 16% range.

Operator: The next question comes from Kelly Motta with KBW. Kelly, please go ahead.

Kelly Motta: I was hoping to get some color around what you’re seeing on the deposit side. You had some good success with lowering deposit costs here in response to the first couple of rate cuts. Wondering how those conversations went, if there’s additional room to lower deposit costs and the cadence of time deposit repricing as we look ahead this year.

Bryan McDonald: Sure, Kelly. Generally, I would say, obviously, the CD repricing is a little bit more programmed than what we’re doing on our exception pricing on the money market accounts, but we have been studying the market and lowering the exception pricing on our money market accounts with each Fed adjustment. Those lagged the Fed cuts a little bit each time, so those are still playing out. But we haven’t seen any major disruption. Most of our competitors, absent a few, have lowered rates. On the CD side, most of the CDs are shorter term, and we have balances rolling off each quarter. Most of those rates are in that $4.15, $4.30 range in terms of what’s rolling off in Q1. We’ve increased, our highest rates are our shorter term rates, and so we’ve seen more of our customers renew into those shorter term balances.

We do have additional detail, if you’d like to cover any of it, I can pass it to Jennifer and she can go through what some of those balances are that are rolling over the next few quarters.

Jennifer Nino: Sure. In Q1, we have about just under $400 million maturing and/or repricing Q2 about $380, so you can see that a significant portion of our CDs are maturing in the first two quarters. We also have some broker deposits that are coming due. We actually have one that’s coming due in the first quarter. We think we’ll probably see a 25 to 50 basis point reduction in that, although it’s not a significant dollar amount. As far as Bryan said earlier as well, just on the regular money market and transaction accounts, we’ll be just highly dependent on the market, whether we can continue to decrease rates.

Kelly Motta: Got it. That’s helpful. You guys continue to work the loan to deposit ratio up to help with profitability, and it looks like from the security sales you took, it doesn’t look like proceeds were reinvested and you were able to leverage the balance sheet a bit. Just wondering, absent further balance sheet restructuring at the margin, if there’s any significant securities maturities upcoming this year and how we should be thinking about managing the loan to deposit ratio ahead and how you’re thinking through the balance sheet that way.

Bryan McDonald: Maybe to start, page 25 of the investor presentation does have those cash flows coming off of the securities portfolio. Deposit growth is one of our top priorities. Obviously, funding the growth with core deposits is critical to generating the profitability absent continuing to do the lost sales and having the proceeds there. But we are comfortable taking the loan to deposit ratio up higher from here, and there is additional opportunities to add deposits. We’ve had really good success. In the fourth quarter, we had a lot of new customer growth. At the same time, we saw customers spending excess money, not taking the money out of the bank to higher rate options as much as using it for distributions or buying real estate or expanding their businesses.

So that was really the driver in the fourth quarter of just the lack of deposit growth that was more use of cash by the customers versus taking the money out and moving it to a higher rate product that was available through a competitor.

Operator: [Operator Instructions]. At this time, we have no further questions, and so I’ll hand the call over to Bryan McDonald for closing remarks.

Bryan McDonald: Okay. Thank you, 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. Thank you.

Operator: Thank you, everyone, for joining us today. This concludes our call, and you may now disconnect your lines.