Hello, everyone, a warm welcome to the Heritage Financial Q3 2024 Earnings Call. My name is Emily, and I'll be coordinating your call today. I will now turn the call over to the CEO, Jeff Deuel, to begin. Please go ahead.

Thank you, Emily. Welcome and good morning to everyone who called in or those who may listen later. This is Jeff Deuel, CEO of Heritage Financial. Attending with me are Bryan McDonald, President and CFO; Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer. Our third 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 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 this presentation during the call. Please refer to the forward-looking statements in the press release. We're very pleased with our operating results for the third quarter, including strong loan growth, deposit growth, margin expansion, and the continued benefits from our expense management efforts. The increases in average earning assets and net interest margin resulted in an improvement in net interest income. We are optimistic the combination of core balance sheet growth and prudent risk management will continue to benefit our core profitability. We will now move to Don, who will take a few minutes to cover our financial results.

Thank you, Jeff. I'll 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 2024. Starting with the balance sheet. Loan growth was strong again in Q3 with loan balances increasing $147 million for the quarter. Yields on the loan portfolio were 5.60%, which was 8 basis points higher than Q2. Bryan McDonald will have an update on loan production and yields in a few minutes. We are very pleased that we also had a strong quarter for deposit growth. Total deposits increased $193 million for the quarter, of which about $83 million was in noninterest-bearing deposits. Although there continues to be a change in the mix of interest-bearing deposits from non-maturity deposit balances to CDs, it is occurring at a much slower pace. The percentage of CDs to total deposits only increased to 16.5% from 16% at the end of Q2. This is net of lowering our broker TD balances by $10 million during the quarter. It is noteworthy that in Q4, we have $420 million of CDs maturing at an average cost of 4.56%. This represents almost half of our total CD balances, which we're expecting to reprice lower due to the decline in market REITs. Due to the normal lag effect in the movement of non-maturity deposit costs after a Fed rate cut, we are not expecting the cost of these deposits to decrease much in Q4 as there continues to be caution for deposit dollars. Our cost of interest-bearing deposits was 2.02% for Q3 compared to 2.03% for the month of September. The spot rate for interest-bearing deposits as of September 30 was 2.04%. The investment balances decreased $86 million, mostly due to the loss trade executed during the quarter. A loss of $6.9 million was recognized on the sale of $71 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 annual pretax income improvement from the loss trade is approximately $3 million, resulting in an earn-back period of about 2 years. In addition to providing funds for loan growth, the combination of investment sales and deposit growth also allowed us to pay down borrowings by $118 million in Q3 from a remaining balance of $382 million at the end of the quarter, of which $64 million are override borrowings and another $148 million mature later in Q4. Moving on to the income statement, net interest income increased $1.8 million, which is 3.6% or 14% on an annualized basis. This improvement from the prior quarter was due to increases in both average earning assets and net interest margin. The net interest margin increased to 3.33% for Q3 from 3.29% in the prior quarter due to a combination of increased loan yields, reduced balances, and higher costing borrowings, partially offset by an increase in the cost of deposits. Please see Page 27 of our investor presentation for more information on net interest income and net interest margin. We recognized a provision for credit losses in the amount of $2.4 million during Q3, which is an increase from $1.3 million in the prior quarter. The provision expense was due to a combination of loan growth and a larger charge-off recognized in Q3. Tony will have an additional information on this charge-off and other quality control credit quality metrics in a few moments. Noninterest expense increased slightly from the prior quarter, but was $1.7 million lower than Q3 2023 levels. We continue to tightly manage FTE levels and expenses in order to lower our overhead ratio, which decreased to 2.18% from 2.21% in the prior quarter and 2.25% in Q3 2023. And finally, moving on to the capital. All of our regulatory capital ratios remain comfortably above low capitalized threshold and our TCE ratio was 9.1%, up from 8.9% in the prior quarter. Our strong capital ratios have allowed us to be active in loss trade on investments and the stock buybacks. During Q3, we repurchased 347,000 shares or approximately 1% of outstanding shares as part of our stock repurchase program at a weighted average cost of $21.40 or 116% of September 30, tangible book value per share. We have 1.16 million shares available for repurchase under the current repurchase plan as of the end of Q3. I will now pass the call to Tony, who will have an update on our credit quality.

Thank you, Don. During the quarter, we experienced total charge-offs of just under $2.7 million, with the majority tied to one owner-occupied CRE loan. The owner occupant has ceased business operations and the final repayment of this loan will be dependent on the sale of the real estate collateral. It is worth noting that this loan was a known problem and has been actively managed by our special assets team since December of 2022. Modest recoveries of $112,000 led to net charge-offs of just over $2.5 million during the quarter. Through the first 9 months of the year, we had just under $2.5 million in net charge-offs representing 0.05% of total loans, which is very much in line with historical norms. By comparison, our average annual net charge-offs for the 3-year period from 2018 through 2020 represented just over 0.07% of average total loans. Nonaccrual loans totaled $4.3 million, and we do not hold any OREO. This represents 0.09% of total loans and compares to 0.08% at the end of the second quarter. Overall, nonaccrual loans increased by $475,000 during the quarter, most of the increase came from the previously mentioned owner-occupied CRE loan. This loan was placed on nonaccrual status during the quarter and then partially charged off at the quarter end. This increase was largely offset by the receipt of SBA guarantee funds on a different loan that fully repaid the outstanding balance of just over $1.6 million. Page 18 of the investor presentation reflects the stability in our nonaccrual loans over the past 2-plus years. Our nonperforming loan totals increased modestly during the quarter, primarily due to our loans past due more than 90 days and still accruing. The majority of the $5.3 million in balances is attributed to one classified C&I relationship that is being actively managed by our special assets team.

Hello, everyone. We apologize for the delay in today's call. Management has lost network connection briefly. We just regained our connection to them and your call will resume momentarily. Thank you for your patience.

Thank you, Emily. Apologies to everyone on the call. This is Jeff. We lost network connectivity at our location. We're back on with our cell phones. Hopefully, with no more interruptions. We're going to go back to Tony's presentation. He was at the point we got cut off referencing Page 18 of the investor deck for more information on nonaccrual loans over the past 2-plus years. So, with that reference, Tony, I'll hand it back to you and let you finish your presentation.

Thanks, Jeff. Our nonperforming loan totals increased modestly during the quarter, due primarily to our loans past due more than 90 days and still accruing. The majority of the $5.3 million in balances is attributed to one classified C&I 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, those rated special mention and substandard totaled $171 million at quarter end, declining by $5 million or 2.9% during the quarter. While still higher than year-end 2023, they have been stable at each quarter end in 2024. It is worth noting that loans in the more severe substandard category were down by just under $11 million during the quarter, from a combination of payoffs, paydowns, and upgrades. At 1.5% of total loans, substandard loans showed stable trends when compared to the 1.6% reflected at year-end 2022 and 2023. Despite the previously mentioned charge-offs, the credit quality of our office loan portfolio remained stable during the quarter. This loan segment represents $554 million or 11.8% of total loans and is split evenly between owner and nonowner-occupied properties. The average loan size is $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 $16 million or 2.9% of total office loans, down from the 3.4% at the end of the prior quarter. Page 17 of the investor presentation provides more detailed information about our office loan portfolio. Overall, we are pleased that our credit quality remained strong at quarter end and believe this reflects our consistent and disciplined approach to credit underwriting and concentration management. I will now turn the call over to Bryan for an update on loan production.

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 $253 million in new loan commitments, up 16% from the $218 million last quarter and up from the $217 million closed in the third 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 third quarter at $491 million, up from $480 million last quarter and up from the $291 million at the end of the third quarter of 2023. The loan demand picked up in the third quarter, with new opportunities more than replacing a strong volume of closed new business. Competitive pressure has continued at an elevated level for both commercial real estate and commercial business loans, but increased activity levels by our bankers along with the new teams we added over the past couple of years are offsetting this pressure and driving the higher production and pipeline levels. Loan growth for the third quarter was very strong at $147 million, up from the $104.5 million of growth we achieved last quarter. The growth was driven by an increase in closed business across the footprint, both from existing and new customers. Please see Slides 14 and 16 of the investor presentations for further detail on the change in loans during the quarter. We previously communicated an expectation of higher construction loan payoffs in the second half of 2024 and moderating loan growth rates, and now it looks like the majority of these payoffs will occur in early 2025, setting us up for a stronger-than-anticipated loan growth through year-end. The deposit pipeline ended the quarter at $165 million compared to $231 million last quarter. The average balance on new accounts opened during the quarter is estimated at $72 million compared to $77 million last quarter, building on the momentum we saw in Q2 deposits, which grew by $193 million during the quarter. The growth was the result of new and expanded relationships, lower outflows of excess customer funds moving to higher rate options elsewhere, and the return of seasonal trends. Moving to interest rates, our average third quarter interest rate for new commercial loans was 6.53%, which is down 35 basis points versus the 6.88% average for last quarter. The decline was due to index rates declining ahead of anticipated Fed action. Loan spreads are holding despite competitive market conditions in the owner-occupied commercial real estate, nonowner-occupied commercial real estate, and commercial construction segments. Additionally, the third quarter rate for all new loans was 6.59%, down 30 basis points from 6.89% last quarter. Before turning the call back to Jeff, I want to highlight the press release we issued yesterday afternoon, which announced the hiring of Nick Bley as our new Chief Operating Officer. Nick is joining from a much larger institution and bringing extensive leadership and banking experience to the team, including deep experience in operations and technology. Filling the Chief Operating Officer position was one of our key staffing-related steps in support of the CEO succession plan we announced in June. We are pleased to have Nick join the executive team and believe he has a lot to offer Heritage as we continue to expand and grow. I will now turn the call back to Jeff.

Thank you, Bryan. As I mentioned earlier, we're pleased with our solid performance in the third quarter, a big thanks to our team for their laser focus on loan and deposit growth, their emphasis on developing long-lasting C&I relationships, and for continuing to focus on expense containment. As Bryan mentioned earlier, we are happy to have the new teams we brought on over the past couple of years, and we can see they are clearly contributing to the loan and deposit expansion we saw this quarter. 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 take advantage of various opportunities to continue to grow the bank. With that said, Emily, we can now open up the line for any questions from the attendees.

Our first question today comes from Jeff Rulis with D.A. Davidson. Jeff, please go ahead.

Thanks. Good morning. Don, if I circle back, Don, on the margin. I appreciate I think you said about a $3 million benefit to the repositioning it took place. Could you just walk us through the margin impact kind of when did that repositioning take place and net that against Fed moves as we move into the fourth quarter, trying to get a sense for where you think we settle in?

Settle in for margin overall, you mean?

Correct.

The trades occurred in both August and September, so we didn't really experience a half-quarter benefit from that. However, the significant impacts came from loan growth and other ongoing factors. Overall, I believe we've reached the lowest point for NIM and I'm optimistic about NIM expansion. In Q4, I expect things to remain fairly steady. Approximately 22% of our loans are floating, and $1.1 billion is set to reprice down by 50 basis points following the September rate cut, which wasn't largely reflected in the loan yields. We also have other factors that will support us this quarter, such as nearly half of our CD balances that will continue to reprice down. We're also looking at reducing some deposit rates, although there is still strong competition for deposits. I anticipate that while we may not see a significant increase in Q4, there is potential for expansion as we move into 2025.

Got it. Thanks, Don. Regarding the pipeline, Bryan, I appreciate the numbers you always provide. I want to frame up our expectations for 2025 a bit. I understand we’re looking ahead, but with the resolution of the construction delay, does that change your overall view for 2025? I know there’s a lot of time left in the year besides the start. Do you have any expectations? I won't annualize the figures from this quarter, but they show about 25%, and all the hires you've made seem active from my perspective.

Yes. mid- to high single digits, likely here in the fourth quarter, looking out to next year, the pipeline going into the fourth quarter, as I mentioned, at $491 million, which is up $200 million over 2023. So that's really positive, and going to drive obviously higher loan closings next year than at least where we started in 2024. If you look at Page 16 of the investor deck, it's got the net advances contributing $142 million to the loan growth year-to-date. And a lot of this has been construction loan commitments that we came into the year with, and those are reflected on Page 14. So, if you look at available credit on Page 14 of the deck, it was $355 million at the end of last year, and at the end of this quarter, it was $199 million. So, what I'm saying is we've got a much stronger pipeline coming in, but lower construction commitments starting off the year. So, we are expecting mid- to high single digits next year, mostly on what happens with the pipeline over the next couple of quarters. But I will say September has been really strong and then the pipeline has also been strong in October. So, we're continuing to see that momentum at least so far in the fourth quarter.

Thank you. Regarding the plan to hire in Seattle and Boise, where do we currently stand? Given that you've brought on many new employees, is a 25% increase this year primarily focused on growth and optimization, or are you still actively looking to add more talent? I'm trying to understand our expenses in relation to staffing, particularly as it relates to the relatively stable expense run rate from the previous quarter.

No, that's okay. Don probably has a couple of comments on run rate. But regarding teams, we always appreciate the organic growth that we're experiencing. The next best option is team lift out. We believe there are potential opportunities out there, but we also recognize that lifting out a team, especially if it’s sizable, can be a significant expense. It seems we are emerging positively from the teams we have brought on, and they are beginning to contribute to our bottom line. I think you will see us be very careful about adding more teams in 2025, meaning they must be very strategic and capable of producing high-quality results quickly. We've had some experience with the costs related to those teams in the past couple of years, but now you can see why we were willing to invest, as it is beginning to positively impact our bottom line. Certainly. To start with Q4, I believe we will experience an uptick in expenses. We have expanded our builder banking team and recently introduced our new Chief Operating Officer, alongside increases in vendor costs. We might expect expenses to rise to approximately $40 million for Q3, and Q1 tends to be challenging due to additional payroll taxes. As the year progresses, we will also encounter wage increases. While we aim to maintain flat full-time employee levels, we anticipate total costs to increase to around $41 million to $42 million for that quarter in 2025.

Maybe first one for Don on those borrowings that are coming due this quarter, the $148 million. Can you just remind us what the cost of those are and what your plans are to do with those, whether or not to pay them off or refinancing?

The weighted average rate mentioned in Slide 40 is still under consideration. We haven't finalized our strategy for those borrowings, whether to place them in overnight funds or to roll them over. Several decisions will be made in November and early December, giving us some time to assess how deposit growth this quarter and potential loss rate adjustments might affect our approach. Ultimately, the cost of those borrowings is expected to decrease significantly.

Yes. Okay. And then thanks for the spot rate on deposits, but what's your expectation for your deposit beta this easing cycle?

It's always again a lag effect some. I don't think we're going to I think it could be similar to what we've experienced going up; we only had, I think, the final beta turned out to be about 30%, right, on it. So, if we could possibly see that happen again. But it will be always a lag effect, again, remember. So, I think again, we'll see some positive lowering of deposit costs as we get further into 2025, but I think it will be kind of slow coming at the beginning.

Okay. On Slide 28, it seems that you have some favorable conditions regarding your loan yields with new production and the fixed and adjustable repricing opportunity. You mentioned that 22% of the portfolio is floating. What are your thoughts on overall loan yields moving forward? They increased by 8 basis points this past quarter. Can we continue to expand loan yields with rate cuts, or do you anticipate that we will begin to decline at some point next year?

I expect that in Q4, we will experience a decrease in loan yields due to the rate adjustment of 50 basis points. However, I believe that generally, we will see increases. We typically base our pricing off of the 5-year rates, which have remained stable, and we were able to issue loans in the low to mid-6s last quarter. I see no reason why we can't maintain that. Currently, we are coming off a rate of $560 million, and the adjustable loans are down to 4%. The fixed-rate loans that are maturing are around 4.5% to 5% in the upcoming quarters. This is quite encouraging because the new loans that replace these will likely be at higher rates, which will offer protection. As we approach 2025, I anticipate an increase in loan yields, but this will largely depend on the Federal Reserve's actions. If rates remain stable, we can expect growth heading into next year after the compression in Q4.

Thanks for taking my questions. A lot of my questions have been answered, but I just wanted to touch on the security portfolio. You continue to be opportunistic there. I'm just kind of curious your appetite for additional sales given the moving rates and expectations of further rate cuts. Do you expect to be more active as rates decline? Just curious any thoughts there.

I don't think we'll be any more active than we've been. We took a $7 million loss last quarter and have fluctuated between $2 million and $10 million losses in previous quarters. I don't expect us to reach those higher losses again, but I believe losses between $2 million and $7 million could still occur. We will make decisions on a quarter-by-quarter basis, considering our current situation, rate trends, and potential earn-back periods. Our choices will aim to aid our future profitability, and it wouldn't surprise me if we take more actions if the rate environment supports that.

Got it. I'm interested in loan growth. It's encouraging to hear that the pipeline has improved and is expected to grow at a mid- to high single-digit pace next year. I'm curious about the pricing and overall composition of the pipeline. In the past, you've supplemented growth with some full purchases. Do you plan to continue that strategy, or do you anticipate sufficient organic growth?

Bryan, you can address that.

Sure. Yes, Eric, it's Bryan. We do have plenty of organic growth at this point, but would consider a mortgage pool purchase potentially next year if we're not hitting the numbers. Page 13 of the investor deck at the bottom segment has detail on the mix of new loan commitments, and C&I has been our highest category for the last 4 quarters and continues to make up the bulk of the pipeline. We have seen fewer non-owner construction and non-owner deals this year, although we're seeing a little bit of an uptick in volume since the Fed cut rates. So, we would expect a similar mix to what you see on Slide 13. On the pricing side, Dan covered this in his response just a minute ago, but I would just add, we saw the 5-year FHLB index decline about 90 basis points during the third quarter, and that was a big driver behind the drop in rates on new loans during the quarter. Total loans fell about 30 basis points, and we've already seen the 5-year Federal Home Loan Bank Index move up 50 basis points in Q4. So, our spreads are holding in there. It's just been the index that's moved and then, of course, prime moved down. But we were more heavily influenced by the Federal Home Loan Bank Index, primarily because a lot of the new commercial customers we bring on and the lines tend to have a lot of unutilized balances and the numbers we quote are based on outstanding balances.

Yes. That's great color. And then just one last question from me and then I'll step back. I just wanted to touch on capital priorities. Obviously, you continue to be active repurchasing stock. Curious how you think about continued repurchases here and M&A talk about being on pause maybe until next year. Just curious how conversations are trending there? And how you think about M&A and capital priorities for now?

So, I'll let Don talk about capital. But on the M&A side, it's pretty much the same as it has been. Conversations continue as a means to keep in touch with targets we're interested in. We're pretty much embedded in the industry, and we're connected to everybody. So, I think if one of the organizations that we really like and think would be a good strategic fit decides to do something, I'm fairly certain that we'll get a call and have the opportunity to react to that. In the meantime, I think we need to continue to focus on improving our financial picture so our currency improves, and we're in a better position to buy when the time comes. Don, how about your comments on capital?

Yes. We continue to, again, monitor our capital positions and needs as opposed to growth. I guess the one point is the fact that we don't see essentially overall balance sheet growing a lot as we might restructure our balance sheet some for less borrowings, maybe leaving less brokered CDs over time. So maybe we grow core deposits, grow loans, but necessarily accounts, you won't grow that much. So, I think that lends it to with our stock price as it was last quarter, it made it attractive to do buybacks. We'll just have to monitor the stock price and that the needs for capital. But again, it wouldn't surprise me if we were involved to the same extent, on more than we did last quarter, but we could do as much as we did last quarter.

Good morning. Just a quick one for me. Just deposit costs. I appreciate the color around some of the CD maturities in the quarter, I think you said $456 million was the kind of coming up rate. Just how does that compare to what you're pricing new CDs at in the market today, kind of so far in the fourth quarter?

Andrew, I don't have a lot of information from the fourth quarter yet. I will say that in September, I think our price was around 4, 40-ish. And then that was before the rate cut. We've actually cut our CD rates since then. So, I would expect that they could possibly reprice 20 basis points, 25 basis points lower, depending on, obviously, the term, but that's an estimate of what could happen on those CDs, but that remains to be seen. Some of them are really rate shoppers; they might go elsewhere over time, but we'll see.

Yes. Okay. I appreciate it. And then maybe just, Jeff, you talked about on the M&A front that there's an organization that you guys think is respected and would be interested in. If they decide to do something, you'll kind of get a call and that makes a lot of sense. So just curious if you could kind of define that a little bit in terms of where you most focused size geography-wise from an M&A standpoint today?

Yes. If you reference Slide 9, which many of you have seen many times, I think our sweet spot is the middle group, the $500 million to $1 billion in assets. I mean we can go lower for the right organization or go higher if the opportunity presents, which seems more remote. And I think you will see us preferably augmenting our footprint along the I-5. We're pretty well set from Vancouver to Bellingham. I think we could fill in Portland South; that would be helpful to us. And obviously, would not object to an opportunity to expand our position in Idaho. I think we've done quite well with the Boise team getting started. They're performing at a very high level. And the argument can be made you can bank Idaho from Boise, but the team will also benefit from having more of a presence in the state with various locations. So, I guess in summary, we want to flush out our position in Oregon along I-5 and expand opportunistically in Idaho. It's not to say we wouldn't consider something in Washington; it would just have to be a good strategic fit and a pretty strong opportunity.

Thank you so much for the question. Most of it has been asked and answered, but just at a high level, considering the pace of your loan growth, you're at $7 billion in assets. I'm wondering if we started to do some work around $10 billion in assets and if any thoughts on your potential rate of growth as you start to edge closer to that in the upcoming years?

Yes, it's a good question. We, a year or so ago, one of our initiatives was to lay out a plan for what we needed to do to prepare to cross $10 billion. We did a fair amount of work on that framework but ultimately set it aside for other strategic initiatives because it didn't appear that our growth rate was going to get us there anytime soon. I think it's probably fair to say that unless a large acquisition presents itself, and that seems pretty remote given what I know about the industry and our markets, it would probably take acquisition to get us there quickly. And I think you'll see us probably just growing at a rate that matches our deposit and loans and how that's impacting our balance sheet. And if you're thinking in that mid-single-digit range, it will, if you just do the math, it's several years away if we don't do an acquisition, and it's probably a few years away if we do. So, we think we have time to prepare, Kelly, and we know what we need to do, and we're making incremental changes in the background because there are certain things we can do now that are not super costly. And I think as soon as we feel like things are going to start ramping, we will get underway and get the framework built.

Great. That's helpful. And then we've just balance sheet management. You've really grown into your deposit base, especially in the last couple of quarters with a really strong loan growth and the security sales helping to incrementally on some of that. You're now in the low 80s kind of approaching where you were prior to deposit balances ballooning in COVID. Wondering, as you look ahead, is that maybe 80% loan-to-deposit ratio still the right way to think about and optimize way for you guys to manage the bank? Or obviously, it takes time to move that around. But I'm just wondering, as we kind of think in the year or two ahead, how we should be managing that.

It's a good question. We spend a lot of time reviewing our risk profile, which includes a factor around loan-to-deposit ratio. Yes, we're happy to see it getting back into the low 80s. I think we would be comfortable having it get into the high 80s but probably not much more than that. I think that that's something that we'll manage as we go through the next year. I would also say to you that I think we have been under-levered for a while. And I think we realized that we need to leverage the balance sheet to hit the kind of numbers we think we should be hitting. And that's going to have to drive that number up a bit.

Thank you, everyone. We have no further questions. And so, I'll turn the call back to Jeff for closing remarks.

Thank you all for your questions. Thank you for being patient with us while we got our connectivity squared away. That's the wrap for our quarterly earnings call. We thank you for your time and your support and your interest, and we'll hope to be talking with many of you in the weeks to come. Thank you, and goodbye.

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