Heritage Financial Corporation (NASDAQ:HFWA) Q1 2024 Earnings Call Transcript April 25, 2024

Heritage Financial Corporation misses on earnings expectations. Reported EPS is $0.4 EPS, expectations were $0.41. Heritage Financial Corporation isn’t one of the 30 most popular stocks among hedge funds at the end of the third quarter (see the details here).

Operator: Hello, and welcome to Heritage Financial Corporation First Quarter 2024 Earnings Call. My name is Lydia, and I will be your operator today. [Operator Instructions] I'll now hand you over to Jeff Deuel to begin. Please go ahead.

Jeff Deuel: Thank you, Lydia. 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, President and Chief Operating Officer; Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer. Our first 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 first quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on 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.

Although there was some noise in the quarter, we're pleased to report a solid core performance including active balance sheet management and expense management activities to reduce noninterest expense. We continue to see pressure on deposit pricing in Q1, and we expect to see that continue for the near term. Deposit balances declined modestly in Q1, and the mix of deposits continues to partially shift to higher rate products. Loan growth was strong in Q1, running at an 8.4% annualized rate. Credit quality remains strong, resulting from our long-term practice of actively managing the loan portfolio. We have ample liquidity, a low loan-to-deposit ratio and a solid capital base. Going forward, we will keep a sharp eye on expenses while we focus on growing loans and deposits.

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

Don Hinson: Thank you, Jeff. I will be reviewing some of the main drivers of our performance for Q1. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the fourth quarter of 2023. I want to start by covering some actions that significantly impacted earnings for Q1, and are expected to help protect future earnings. First, we repositioned a portion of our investment portfolio, which resulted in a pretax loss of $10 million during Q1, which is similar to the loss recognized in Q4. We sold $144 million of securities with a weighted average yield of 2.37% and purchased $33 million of securities yielding 6.05%. Including the yield on cash not reinvested at quarter end, we are expecting an annualized net interest income pickup of about $4.6 million from these transactions, resulting in an earn-back period of approximately 2.5 years.

Unlike the trade in Q4, where we reinvested substantially all of the proceeds, we intend to use a portion of this quarter's proceeds for other cash needs, such as the BTFP debt that matures in early May. Second, we incurred certain costs related to expense management measures in order to lower expenses in future periods. For Q1, these primarily included severance costs of $1.1 million due to reduction in staffing levels, which we mentioned during our previous earnings call in January. These costs in aggregate with expense management costs occurred in Q4 are expected to improve the annualized expense run rate by $5.3 million. Please see Page 6 of the investor presentation for more information on these actions. Moving on to the balance sheet.

Loan growth was strong in Q1, as mentioned by Jeff, increasing $92.5 million for the quarter. Most of this growth occurred in the latter portion of the quarter, and the benefits won't be fully realized until Q2. Yields in the loan portfolio were 5.41% for the quarter, which was 6 basis points higher than Q4. Bryan McDonald will have an update on loan production and yields in a few minutes. Total deposits decreased $67.5 million during the quarter. This was due to a decrease of $154 million in non-maturity deposits, approximately half of which was due to declines in noninterest-bearing deposits, partially offset by an increase of $87 million in CD balances. 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 22 basis points in our cost from spring deposits to 1.70% for Q1. Due to the market -- current market pressure related deposit rates, we expect to continue to experience an increase in the cost of our core deposits. This is illustrated by the cost of interest-bearing deposits being 1.78% for the month of March, with a spot rate of 1.80% as of March 31. Investment balances decreased $143 million during Q1, mostly due to the loss trade previously discussed. The security trades occurred in March, therefore, the benefits of the loss trade was not fully realized in Q1. Even without full realization of the loss trade benefit, the yield on the securities portfolio increased 15 basis points from the prior quarter to 3.30% for Q1.

Moving on to the income statement. Net interest income decreased $2.3 million from the prior quarter, due to a decrease in both the net interest margin and average earning assets. The net interest margin decreased to 3.32% for Q1 from 3.41% in the prior quarter. This decrease was primarily due to the cost of bearing deposits increasing more rapidly than yields on earning assets. Although the impact of the loss trade will partially mitigate other factors, 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 of deposits as well as the 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 provision for credit losses in the amount of $1.4 million during Q1, which is similar to the provision expense in Q4. The provision expense was due substantially to loan growth experienced during the quarter. Noninterest expense decreased from the prior quarter due to lower FTE levels and lower costs related to contract renegotiations, partially offset by higher severance costs. Average FTE was 765 in Q1 compared to 803 in Q4, a reduction of 38 FTE. As was communicated in the last earnings call, we expect the expense run rate to be between $40 million and $41 million for the remainder of the year. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio remained at 8.8%. Our strong capital ratios have allowed us to be active and lost trades on investments and in stock buybacks.

During Q1, we repurchased approximately 330,000 shares at a weighted average cost of $18.56 or 107% of March 31 tangible book value per share. As we announced in the earnings release, the Board has approved a new share repurchase plan in the amount of 5% of outstanding stock, which equates to 1.7 million shares. As we have done in the past, we will use the share repurchase plan to manage our capital levels. I will now pass the call to Tony, who will have an update on our credit quality metrics.

Tony Chalfant: Thank you, Don. I'm pleased to report that credit quality at quarter end remained strong and stable. As of quarter end, nonaccrual loans totaled just under $4.8 million, and we do not hold any OREO. This represents 0.11% of total loans and compares to 0.10% at the end of 2023. Nonaccrual loans increased by $324,000 during the quarter. Increases of just under $600,000 in the quarter came primarily from moving one C&I loan to nonaccrual status. Partially offsetting this increase was $269,000 in loans that were either upgraded to accruing status or were paid off during the quarter. Page 18 of the investor presentation reflects the consistently low level of nonaccrual loans we've experienced over the past 2 years.

Loans that are delinquent more than 30 days and still accruing stood at 0.21% of total loans at year-end, up from 0.11% at year-end 2023. Most of the increase is attributed to one classified relationship that is being actively managed by our special assets team. The loans remain on accrual status as they are well secured and in the process of collection. Criticized loans totaled just over $172 million at the end of the quarter. This is an increase of $22 million over year-end 2023, almost entirely in the special mention category. The largest driver of this increase was the downgrade of one multifamily commercial real estate loan that represented just over $15 million of the total. Overall, criticized loans have trended modestly higher over the last 12 months.

However, remain in line with our historical performance with good economic conditions. Criticized loans at quarter end were 3.9% of total loans as compared to 3.5% at year-end '23 and 3.3% at the end of 2022. The credit quality of our office loan portfolio remained stable in the quarter. This loan segment currently represents $551 million or 12.4% of total loans and is split evenly between owner and nonowner occupied properties. The loans continue to be granular in size and diversified by geographic location, with little exposure in the core downtown markets. Criticized office loans are limited to just over $18 million, which is down modestly from the $19.2 million reported at the end of 2023. We recently completed the targeted review of all significant office loans that have either a maturity or a repricing event over the next 2 years.

The review focused on the adequacy of debt service coverage using current operating income and note rates, along with an estimated loan-to-value ratio using current cap rates. The review included 41 loans with $93 million in total outstanding balances. I'm pleased to report that we did not downgrade any loans to special mention or worse during this review. Page 17 of the investor presentation provides a more detailed information about our office loan portfolio. During the quarter, we experienced total charge-offs of $200,000. The losses were offset by $233,000 in recoveries, leading to a net recovery position of $33,000 at quarter end. We continue to experience lower loan losses than historical norms. While we saw some modest deterioration in the first quarter, the credit quality of our loan portfolio remains strong.

As we have discussed in prior quarters, we continue to see a slow move back to a more normalized credit environment, following a period of exceptionally high credit quality. We remain consistent in our disciplined approach to credit underwriting, and we 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 loan production.

Bryan McDonald : Thanks, Tony. I'm going to provide detail on our first quarter loan production results, starting with our commercial lending group. For the quarter, our commercial teams closed $133 million in new loan commitments, down from $187 million last quarter and down from $228 million closed in the first quarter of 2023. Please refer to Page 13 in the investor presentation for additional detail on new originated loans over the past 5 quarters. The commercial loan pipeline ended the first quarter at $409 million, up from $329 million last quarter and down from $587 million at the end of the first quarter of 2023. Loan demand showed improvement in the first quarter and new opportunities have continued to present themselves at the same level during April.

Competition remains very high for quality commercial business, but we anticipate the pipeline will continue its upward trajectory in the second quarter. Loan growth for the first quarter was $92.5 million, up from $69 million last quarter, due to higher loan balances relative to commitments on loans closed during the quarter, lower prepayments and payoffs and higher net advances on construction loans. Please see Slides 14 and 16 of the investor presentation for further detail on the change in loans during the quarter. Based on a higher projected level of construction loan payoffs in the second quarter and our building loan pipeline, we anticipate loan growth rate -- our loan growth rate will be mid-single digits near term and move back up to the first quarter levels in the second half of 2024.

The deposit pipeline ended the quarter at $191 million compared to $207 million last quarter, and estimated average balances on new deposit accounts opened during the quarter are $40 million compared to $55 million last quarter. Moving to interest rates. Our average first quarter interest rate for new commercial loans was 7.05%, which is 12 basis points higher than the 6.93% average for last quarter. In addition, the first quarter rate for all new loans was 7.15%, up 11 basis points from the 7.04% last quarter. The market continues to be competitive, particularly for C&I relationships. I will now turn the call back to Jeff.

Jeff Deuel: Thank you, Bryan. As I mentioned earlier, we're pleased with our accomplishments for the first quarter of 2024. While we continue to experience the challenges of the rate environment on our deposit franchise, we're confident that the strength of the 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. We will continue to benefit from our solid risk management practices and our strong capital position, and we will continue to focus on expense management, 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 Lydia, we are ready to open the call up to any questions callers may have for us.

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