Earnings Call Transcript - HFWA Q4 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial Earnings Conference Call. At this time, your telephones lines are in a listen-only mode. Later there will be an opportunity for question and answers and instruction given at that time. As a reminder, our call today is being recorded. I'll now turn the conference call over to your host, President and CEO, Jeff Deuel. Please go ahead.

Jeff Deuel, CEO

Thank you, Alan. Welcome to all who called in and those who may listen later. This is Jeff Deuel, CEO of Heritage. Attending with me are Don Hinson, our Chief Financial Officer; Bryan MacDonald, our Chief Operating Officer; and Tony Chalfant, our Chief Credit Officer. Our earnings release went out this morning premarket, and hopefully, you have had the opportunity to review it prior to this call. We have also posted an updated fourth quarter investor presentation on our Investor Relations portion of our website. Please refer to the forward-looking statements in the press release.

Don Hinson, CFO

Thank you, Jeff. As reported in our earnings release, we recognized earnings of $0.66 per share in Q4 compared to $0.46 in Q3. We also reported a $3.3 million or 15% increase in our pretax pre-provision income from the prior quarter. Before digging further into the income statement, I'm going to start by reviewing the balance sheet. Starting with loans. Our loans receivable decreased $198 million from Q3. This decrease was primarily due to a $153 million decrease in SBA-PPP loans as a result of the forgiveness process. In addition, we had decreases of $32 million in consumer loans and $17 million in C&I loans. The decrease in C&I loans balances was mostly due to a decrease of $13 million in two large relationships. Consumer loan balances are decreasing mainly due to indirect auto loans, which we ceased originating early in 2020. Indirect auto loans decreased $27 million in Q4, and we expect that to approximate the runoff in future quarters. Bryan McDonald will discuss loan production in a few minutes. Deposits decreased $91 million in Q4 due primarily to a decrease of $96 million in one public deposit relationship. This was an investment account for the public entity, as opposed to an operating account, and we decided not to pay the higher rate due to our significant liquidity position. Moving on to the allowance for credit losses. In Q4, we recognized a reversal of provision for credit losses in the amount of $3.1 million compared to a provision of $2.7 million in Q3, which favorably impacted pretax income by $5.9 million quarter-over-quarter. The total reversal of provision for Q4 included a reversal of provision for unfunded commitments in the amount of $341,000. At the end of Q4, the allowance for credit losses on loans was 1.57%, which is unchanged from the percentage at the end of Q3. Excluding PPP loans, which are guaranteed and not provided for, the allowance for credit losses on loans was 1.87% at December 31, a decrease from 1.93% at September 30. This lower allowance percentage was due to a decrease in allowances on individually evaluated loans as well as slight improvements in the economic forecast from the prior quarter. Due to various factors, including government stimulus programs, charge-offs in 2020 have been lower than we originally expected at the beginning of the pandemic. Net charge-offs for 2020 were only 7 basis points. The magnitude of future provisions will be dependent on a combination of factors, including economic forecasts, charge-off experience, and loan growth. Tony Chalfant will discuss credit quality metrics in a few minutes.

Tony Chalfant, Chief Credit Officer

Thank you, Don. Regarding credit quality, our net charge-offs for the fourth quarter were $363,000, and this was primarily attributed to the partial charge-off of a commercial construction loan that was impacted by cost overruns and construction delays. Net charge-offs for the year totaled $3.2 million, which was very similar to what we experienced in 2019. We also experienced an increase in nonaccrual and potential problem loans due to the ongoing impacts of COVID-19.

Bryan McDonald, COO

Thanks, Tony. I'm going to provide detail on our fourth quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $140 million in new loan commitments, down from $181 million last quarter and down from $306 million closed in the fourth quarter of 2019. The commercial loan pipeline ended the fourth quarter at $413 million, up 7% from $386 million last quarter and up from $390 million at the end of the fourth quarter of 2019. New loan demand continues to be negatively impacted by COVID-19, but our bankers report increased discussions with customers on capital projects, expansion plans, and bank transitions, which makes us cautiously optimistic that this will translate into higher loan volume in the second half of the year.

Jeff Deuel, CEO

Thanks, Bryan. As I mentioned earlier, we're pleased with our performance to date. Our primary concerns remain with borrowers in the high-risk loan categories, which is not new. These businesses make up the vast majority of the increase in nonaccrual and potential problem loan categories. As in the past, you will see these loan categories ebb and flow quarter-to-quarter as we work with our customers. I encourage you to focus on net credit losses, which historically have been relatively low due to our conservative risk profile and well-discussed concentration management system. While we are feeling better about the big picture at this point, we are still facing several uncertainties around the vaccines, the economy, the political climate, and ongoing social unrest in several of our core metro markets, which could potentially impact our performance. However, for now, we're comfortable with our position, and we believe the impact of the pandemic on our loan portfolio will be much more subdued than we originally anticipated. As Don mentioned earlier, we believe our current capital levels are adequate, and our robust liquidity provides us with a solid foundation to address challenges and also take advantage of opportunities. We are focused on what we can control, including managing risk, managing expenses, and continuing to develop the technology we need to deliver consistent long-term performance. That is the conclusion of our prepared comments. So Alan, we are ready to open up the call now and welcome questions that any of you may have.

Operator, Operator

Our first question will come from the line of Matthew Clark with Piper Sandler. Go ahead.

Matthew Clark, Analyst

Maybe if we could just start on the expense run rate and kind of the technology reinvestment needs and the things you're working on this year. I guess how should we think about the puts and takes around expenses?

Don Hinson, CFO

Matt, let me provide you some insight on that. Just as a reminder, our Q4 expenses are typically the lowest of the year, while our Q1 expenses are usually the highest. Essentially, the first couple of quarters tend to have higher costs, which then decrease due to various factors. In relation to that, we have significant exit costs related to branches in Q4. We will also realize savings from not operating those branches in Q1, primarily in Q2. A few exit costs remain, but we also have technology-related expenses and costs associated with the forgiveness of new PPP originations. Looking ahead, I anticipate that due to the expenses we didn't incur last Q1, we'll have some savings at the same time that we'll likely be close to where we were last Q1. However, this will still depend on several factors regarding our PPP spending.

Matthew Clark, Analyst

And just to clarify, I mean, you're talking about that $37 million run rate a year ago, excluding exit costs, which we'd likely back out?

Don Hinson, CFO

I believe that our net will be more similar to Q1 of last year than to Q4 or even Q3 of this year. So, to summarize.

Matthew Clark, Analyst

Got it. Okay. And then just on the opportunities to higher teens in your markets, it sounds like there's a fair amount of disruption in the Northwest. Are you in talks with anyone these days? Are you at a point where you're close to hiring some bankers here in the near term?

Jeff Deuel, CEO

Well, Matt, you know from prior conversations that we're always open to consider high-performing teams joining us, and we've successfully done that both in Seattle and in Portland. We're typically always in conversations with folks in the industry, whether they be people looking for a change or, quite frankly, other banks. So it's really up to us to determine the timing because up till now, we've been reluctant to bring on teams with all the uncertainty around us. And I think it's possible that we could do something this year, but we haven't been rushing to do it because we're waiting for everything to settle down first.

Matthew Clark, Analyst

Okay. And then just on the M&A side of the equation, can you give us an update there? Have conversations started to pick up more meaningfully? And do you expect to get something done this year?

Jeff Deuel, CEO

Much like everybody else, we are hopeful that there will be more activity as the year progresses, probably more in the latter part of the year. But we've been pretty diligent throughout the whole COVID experience, keeping in contact with people we know in the industry. So they can see how we're doing and what we're up to, and that has served us well over the past couple of years in terms of keeping people informed so that if they decide to do something, we get a call. I think the conversations may have gotten a little bit more interesting in the last month, but I wouldn't say it's significantly different.

Matthew Clark, Analyst

Okay. And then, Don, can you just give us the remaining amount of net PPP fees left from round one?

Don Hinson, CFO

Yes. I think it's a little over $15 million.

Operator, Operator

We'll go next to the line of Jeff Rulis with D.A. Davidson. Go ahead.

Jeff Rulis, Analyst

I have a question regarding the expense number mentioned by Don. Are you indicating that it aligns more with Q1 of '20 rather than Q4 of '20? Can you confirm the balance based on what you typically said? Additionally, will the trend show a decline from the Q1 level of '21 for the remainder of that year?

Don Hinson, CFO

Yes. Jeff, I'll try to clarify that. So yes, I expect expenses to be closer to Q1 of '20 for the next couple of quarters based on the costs. Hopefully, we can continue to work that down over time. But I do expect it to be close to Q1, based on offsetting factors that always hit us in the first part of the year.

Jeff Rulis, Analyst

Yes, I understand. I'm attempting to eliminate some of the exit costs, and that information is helpful.

Don Hinson, CFO

The factors I mentioned are just to provide you with an overview of that.

Jeff Rulis, Analyst

I appreciate it, Don. The branch closures you've identified or executed seem to be based on various decisions. However, I'm unsure if there was a consistent approach to judging these closures based on profitability, metropolitan versus rural areas, or the proximity of other branches. Were there any themes you were considering when assessing the network?

Jeff Deuel, CEO

I think what you primarily saw us do, Jeff, was rationalize branches that were close to others based on proximity for the most part. This is partially a result of some of the new insights we've gained this year into our customers' activities. Many people have signed up for online and mobile services, leading us to realize that the number of branches does not need to be as extensive as it once was. We will continue to evaluate the rest of the footprint, and over time, you will see us gradually reduce the broad footprint where it makes sense.

Jeff Rulis, Analyst

Okay. Jeff, with the reinstatement of the buyback, does that impact our view on M&A opportunities? Or is it simply a matter of wanting to keep that option available and use it when appropriate? We shouldn't overreact to the reinstatement; it's more about feeling comfortable with the macro environment.

Jeff Deuel, CEO

Yes. I think that was a good way of putting it. It's just one of the tools we have, and in the right circumstances, we want to be able to use it. And if it makes sense. But no, I don't think you should overreact to us announcing that we're bringing it back. Don, anything you want to add to that?

Don Hinson, CFO

No, I think you covered that.

Jeff Rulis, Analyst

Okay. And last one, just maybe for Bryan. It seems you've got a little kind of creep in the NPA figure, but with the recapture, my guess is those that migrated to nonaccrual were certainly on watch and reserve for? And just understanding that the direction of the reserve is more indicative of growing comfort than maybe watching the NPA level. Anything you could expand on kind of reserve levels and additional release into '21?

Bryan McDonald, COO

Don, maybe you want to take the reserve piece and then maybe Tony comment on credit quality.

Don Hinson, CFO

I apologize. I mean, Tony, sorry about that.

Bryan McDonald, COO

No problem.

Don Hinson, CFO

Sure, I can discuss provisioning. There are several factors at play, including our loan growth. Regarding the recent increase in non-performing assets, we didn't need to make additional provisions due to the collateral valuations. We felt confident about not adding any provisions in this case. We'll continue to monitor the economy closely, particularly in sectors facing more difficulties. Overall, the outlook appears more positive compared to the previous quarter. Given the current conditions in the local economy, we didn't believe it was appropriate to release too much of our provisions. While some adjustment was necessary due to changes in loan balances, we felt it was best to maintain our current provisions for now. If we continue to avoid charge-offs, we will eventually need to reinstate some provisions, but it's uncertain whether charge-offs are merely delayed or if they will be less significant than we initially anticipated. It’s still early to tell. Tony, would you like to add anything?

Tony Chalfant, Chief Credit Officer

Yes, thanks, Don. Jeff, to address your question, if I miss anything, please let me know. The bank has identified nearly all the credits that were at risk by the end of the second quarter. The second half of the year has primarily focused on managing that portfolio and observing borrowers who are moving into higher risk categories, including special mention and substandard, while also monitoring nonaccrual and trouble debt restructuring situations. We feel confident at the end of the year that the portfolio has been properly identified and segmented. Going forward, we will be managing a smaller group of loans than we initially anticipated earlier in 2020.

Operator, Operator

We'll go to the line of Jackie Bohlen with KBW. Go ahead.

Jackie Bohlen, Analyst

I apologize if this is a little technical of a question, but what kind of an effect did the decline in indirect auto have on the release this quarter from the provision standpoint? Just broadly, if it was a factor as well.

Don Hinson, CFO

Jackie, you can just probably take the provision expense we have. I don't think it might have a higher percentage. I don't remember off the top of my head, what percentage we're applying to indirect auto, probably higher than what we've gotten there at 2% because it's much higher than, say, commercial real estate. I don't remember exactly what it was. But if you take that decline in balance of $27 million and take it, say, it might be 3%, might be closer to what we allow for that. That might be an impact on that.

Jackie Bohlen, Analyst

Okay. I mean, I guess where I'm going just broadly is wondering if part of that portfolio being in runoff mode, absent any other changes, is going to cause the ratio itself to kind of gradually trickle down as the risk profile shifts a little bit.

Don Hinson, CFO

I would say marginally, but we're also down to about $200 million for the whole portfolio. So it will have less and less of an impact.

Jackie Bohlen, Analyst

Okay. And then the two C&I loans that were called out as having the decline in the quarter, the two significant relationships. Was that intentional or was that driven by something else? In function on your part.

Tony Chalfant, Chief Credit Officer

Yes. Actually, Bryan, you might have a better idea on that. That's the ones that paid off in the quarter that the larger relationships.

Bryan McDonald, COO

Yes. Jackie, this is Bryan. We did have elevated payoffs and pay downs in the quarter. And both of the large ones I’m thinking of were both business sales, but we also had some refinancing, which wasn't those two, but that was the other big driver kind of coming back in perhaps just as the economy as people have a little better visibility. Of course, rates are very low, so we didn't see a lot of refinancing activity in Q2 or Q3, but we saw more in Q4 and then a resumption of some of the business sales we were seeing last year.

Jackie Bohlen, Analyst

Okay. And I mean, just based on the pipeline numbers you gave, it sounds like setting payoffs aside from an origination standpoint, it sounds like you're fairly well situated into the year. And then maybe more optimistic for a pickup as things start to open up, hopefully, in the latter half? Is that a good characterization?

Bryan McDonald, COO

That's true. Right now, of course, we've got everyone focused on getting their customers through PPP, although that was a much shorter window of time where we are fully focused on it. We're already well over the high point and this week, closing a lot of loans, but by the time we get it next week, I think we won't be back to normal because we'll still be working on it, but much less of a focus and with the vaccine rollout and the economy continuing to open up, we do see the second half of the year with a lot more potential.

Don Hinson, CFO

Jackie, we usually don't express exuberance about our future outlook. However, it's important to remember that before the COVID-19 pandemic, the region was performing quite well, and there is still considerable activity occurring beneath the surface. We recently came across an article highlighting that the Seattle market is among the top 10 most active economies in the country. Although the pandemic has cast a shadow over everything, once we begin to move past that pressure, there is significant potential in this region. It’s worth noting that we are still relatively new to the metro markets, so there is plenty of work ahead. Furthermore, from our first round of the Paycheck Protection Program, we gained a solid number of new prospects, and they are still coming in, albeit at a slower pace due to remote work and other distractions. Additionally, Microsoft and Amazon continue to expand significantly in our area, and housing prices remain strong. All these factors contribute to the cautious optimism Bryan mentioned for the latter half of the year, especially if the vaccine distribution progresses positively.

Jeff Deuel, CEO

Jackie. This is Don. Just while others were talking, I did check in about $500,000 of the release this quarter was due to the decline in indirect auto balances.

Operator, Operator

We have no further questions in queue at this time.

Jeff Deuel, CEO

Well, if there's no more questions, then we'll wrap up this quarter's earnings call. Thank you all for participating. We appreciate your support and your interest, and I think we're going to see or at least talk with some of you in the coming weeks. So looking forward to that. And thank you very much for joining us.

Operator, Operator

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