Earnings Call Transcript - HFWA Q2 2025

Operator, Operator

Hello, everyone, and a warm welcome to the Heritage Financial 2025 Q2 Earnings Call. My name is Emily, and I'll be coordinating your call today. I would now like to hand the call over to our host, Bryan McDonald, President, to begin. Please go ahead.

Bryan D. McDonald, CEO

Thank you, Emily. Welcome, and good morning to everyone who called in or those who may listen later. This is Bryan McDonald, CEO of Heritage Financial. Attending with me are Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer. Our second quarter earnings release went out this morning premarket, and hopefully, you have had an opportunity to review it prior to the call. We have also posted an updated second 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. Improving net interest margin and tight controls on noninterest expense growth continued to incrementally drive earnings higher in the second quarter. On an adjusted basis, earnings per share were up 8.2% versus last quarter and up 17.8% versus the second quarter of 2024. We are optimistic these trends will continue, and combined with prudent risk management, will provide progressively higher profitability as we finish out 2025. We will now move to Don, who will take a few minutes to cover our financial results.

Donald J. Hinson, CFO

Thank you, Bryan. I will be reviewing some of the main drivers of our performance for Q2. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the first quarter of 2025. Starting with the balance sheet. Total loan balances increased $10 million in Q2 as loan originations increased from Q1, but payoffs and prepayments remain elevated. Yields on the loan portfolio were 5.50%, which is 5 basis points higher than Q1. This was due primarily to new loans being originated at higher rates and adjustable-rate loans repricing higher. Bryan McDonald will have an update on loan production and yields in a few minutes. Total deposits decreased $60.9 million in Q2 due to the seasonal decline that occurred in April related to tax payments. However, average total deposits increased $35.4 million from the prior quarter. This marks the fifth consecutive quarter of us showing an increase in average total deposit balances. The cost of interest-bearing deposits increased to 1.94% from 1.92% in the prior quarter. Although we may see decreases in costs in certain deposit categories such as CDs, we don't expect overall decreases in the cost of interest-bearing deposits absent further rate cuts by the Fed. Investment balances decreased $67.6 million, partially due to a loss trade executed during the quarter. A pretax loss of $6.9 million was recognized on the sale of $91.6 million of securities. These sales were part of a strategic repositioning of our balance sheet. A portion of the proceeds was reinvested in $56.4 million of securities, and the remaining proceeds were used for other balance sheet initiatives such as the funding of higher-yielding loans. Moving on to the income statement. Net interest income increased $1.3 million or 2.4% from the prior quarter due to a combination of a higher net interest margin and more days in Q2 compared to the prior quarter. The net interest margin increased to 3.51% from 3.44% in the prior quarter due primarily to increases in loan and investment portfolio yields. We recognized a provision for credit losses in the amount of $956,000 during the quarter due partially to loan growth and partially to net charge-offs. Tony will have additional information on credit quality metrics in a few moments. Noninterest expense decreased $298,000 from the prior quarter due mostly to lower benefit costs and payroll taxes, as well as lower data processing vendor costs. These decreases were partially offset by higher professional services expense, which is partially related to achieving the lower vendor costs. We continue to guide in the $41 million to $42 million range for quarterly noninterest expenses this year. And finally, moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio was 9.4%, up from 9.3% in the prior quarter. Our strong capital ratios allow us to be active in loss trades on investments and stock buybacks. During Q2, we repurchased 193,700 shares at a total cost of $4.5 million under our current share repurchase plan. We still have 797,000 shares available for repurchase under the current repurchase plan as of the end of Q2. I will now pass the call to Tony, who will have an update on our credit quality.

Anthony W. Chalfant, CRO

Thank you, Don. While we saw some modest deterioration during the quarter, the credit quality of our loan portfolio remains strong. Nonaccrual loans totaled just under $9.9 million at quarter end, and we do not hold any other real estate owned. This represents 0.21% of total loans and compares to 0.09% at the end of the first quarter and 0.08% at the end of 2024. The largest addition during the quarter was a $6 million multifamily construction loan. That project is nearly complete and is expected to begin leasing units in the third quarter. There is currently no loss expected on this loan, and the nonaccrual decision was primarily tied to the delinquency status. Also contributing to the increase was a commercial and industrial loan that totaled $1.7 million when moved to nonaccrual status. During the quarter, we charged this loan down to $1.3 million that is covered by the SBA guarantee. Including this loan, we have just over $2.3 million in government guarantees tied to this nonaccrual loan portfolio. Page 18 of the investor presentation shows the low level of nonaccrual loans we have experienced over the past three-plus years. Nonperforming loans increased from 0.09% of total loans at the end of the first quarter to the current level of 0.39%. In addition to the previously mentioned increase to nonaccrual loans, we have three loans totaling $8.6 million that are over 90 days past due and remain on accrual status. These loans are well-secured and in the process of collection. While they are past their maturity date, they continue to make their monthly interest payments. All are expected to be either extended or paid in full during the third quarter. Criticized loans that are special mention and substandard totaled just under $214 million at quarter end, increasing by $35.8 million during the quarter. Most of this increase was in the substandard category with several larger loan relationships downgraded from special mention during the quarter. The biggest driver of the increase is a $14.7 million, non-owner-occupied commercial real estate loan that is currently not generating adequate cash flow to service debt. Also contributing to the increase was the downgrade of two related owner-occupied commercial real estate loans, where the owner occupant is experiencing cash flow difficulties. At 2.1% of total loans, substandard loans remain at a manageable level and in line with our longer-term historical performance. During the quarter, we experienced total charge-offs of $558,000 that were largely tied to our commercial portfolio. The losses were offset by $64,000 in recoveries, leading to net charge-offs of $494,000 for the quarter. For the first six months of this year, we have had $793,000 in net charge-offs. This represents 0.03% of total loans on an annualized basis and compares favorably to the 0.06% we reported for the full year 2024. Page 21 of the investor presentation shows our history of low credit losses and how it compares favorably to our peer group. While we have some concern with the increase in nonperforming and substandard loans this quarter, we believe it reflects a continued return to a more normalized credit environment after a period of unprecedented credit quality for the bank. We will continue to closely watch for areas of stress in the economy that could impact our credit quality. We remain consistent in our disciplined approach to credit underwriting and 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 Bryan for an update on our production.

Bryan D. McDonald, CEO

Thanks, Tony. I'm going to provide detail on our second quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $248 million in new loan commitments, up from $183 million last quarter and up from $218 million closed in the second quarter of 2024. 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 second quarter at $473 million, up from $460 million last quarter and down modestly from $480 million at the end of the second quarter of 2024. During the quarter, we continue to see tariffs and other uncertainties causing some of our customers to suspend capital plans. This is reflected in a pipeline that is relatively flat quarter-over-quarter versus showing a seasonal increase, which is what we saw last year and would be more typical. That being said, we are estimating third quarter commercial team new loan commitments of $300 million or 20% higher than the second quarter. Loan balances were up $10 million in the quarter after a decline of $37 million in the first quarter. Although production was up $65 million versus last quarter, we continue to see elevated payoffs and prepaids. And similar to last quarter, the mix of loans closed during the quarter resulted in lower outstanding balances. Looking year-over-year, prepayments and payoffs are $59 million higher than last year, and net advances on loans have swung from a positive $106 million last year to a negative $26 million year-to-date in 2025. Please see Slides 14 and 16 of the investor presentation for further detail on the change in loans during the quarter. Looking ahead to the third quarter, we expect loan balances to be relatively flat due to construction loan paydowns and payoffs increasing further. After the third quarter, we expect loan growth to resume as construction loan payoff activity returns to a normalized level. Deposits decreased during the quarter, but are up $100 million year-to-date versus a decline of $82 million for the same period last year. A decline in deposits similar to what we saw in 2024 is more typical of seasonal flows. The deposit pipeline ended the quarter at $132 million compared to $165 million in the first quarter, and average balances on new deposit accounts opened during the quarter are estimated at $72 million compared with $54 million in the first quarter. Moving to interest rates. Our average second quarter interest rate for new commercial loans was 6.55%, which is down 28 basis points from the 6.83% average for last quarter. In addition, the second quarter rate for all new loans was 6.58%, down 31 basis points from 6.89% last quarter. These average rates are based on outstanding loan balances. The drop in average rates is due to the funding mix of new loans during the quarter and, to a lesser extent, the 16 basis point decline in the 5-year Federal Home Loan Bank Index during the quarter. Using commitment amounts versus outstanding balances for all new loans closed during the quarter, the average rate was 6.80% versus 6.86% on commitment balances for the first quarter or a decline of only 6 basis points. In closing, as mentioned earlier, we are pleased with our solid performance in the second quarter. Yields on loans and investment securities continue to increase, driving earnings higher versus the first quarter and the same quarter last year. 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 the various opportunities to continue to grow the bank. With that said, we can now open the line for questions from call attendees.

Operator, Operator

Our first question comes from Jeff Rulis with D.A. Davidson.

Jeffrey Allen Rulis, Analyst

Don, on the loss trade, do you have a projected earn-back on that as kind of the timing? And then what the expected near-term margin impact would be or benefit?

Donald J. Hinson, CFO

Well, we have it actually on page we happen to see on Page 6 of our investor presentation, we have kind of that information for Q2. It's approximately a 3-year earn-back on the Q2 activity. In total, we've been doing about 2 years in total, but it was a little longer in Q2. But the pickup is estimated at about $0.05, I'm sorry. So, or $2.3 million pretax. So I don't have the exact yield pickup for you, but you can figure that out with those numbers.

Jeffrey Allen Rulis, Analyst

Okay. And I guess, Don, we've talked in the past about sort of this maybe winding down on the risk structures, but maybe just checking back in the second half of the year, do you foresee much more of this activity?

Donald J. Hinson, CFO

As it always is for every quarter, it will depend on 2 things: what the market is going to give us and our needs for capital. You'll notice that some quarters are higher than others. We've always done a little something every quarter. We're always looking to improve the overall performance. So I think that you might see something done, but it will all depend. It could be very small to something we've done in the past, but probably not outside the range of what we've been doing over the last few quarters.

Jeffrey Allen Rulis, Analyst

Got it. You mentioned the capital impact and maybe for Bryan, I wanted to just check in on other forms of use on the buyback and if there's anything other strategic use of capital that considering or conversations on that front.

Bryan D. McDonald, CEO

Yes. I'll let Don discuss the buyback, and then I'll address the other part.

Donald J. Hinson, CFO

Sure. I think our stock price was favorable in Q2. As you noticed, we didn’t make any moves in Q1. This can change depending on our stock price and other requirements. Additionally, in Q1, we were keeping an eye on certain concentrations in our non-owner-occupied commercial real estate loans. Therefore, I’m cautious about providing any specific guidance on what we plan to do in Q3, but we do still have some shares remaining in our repurchase plan, and much will depend on the circumstances during the quarter.

Bryan D. McDonald, CEO

And just picking up, Jeff, on the other uses from an organic standpoint, our loan production has actually really been strong. We had a couple of hundred million in Q1, $267 million in Q2. Now these are for the total bank. The numbers I mentioned in the script were just for commercial. And then we're projecting something over $300 million for next quarter. The mix hasn't had as much in the way of funding percentages as what we had last year, but the big change is payoffs and in particular, just cycling of our construction portfolio. We had net advances last year that were pretty significant in that category, and we're just seeing those cycle through. So a long way of saying, at least as it relates to Q3, we're not expecting to need a lot of capital to support an oversized level of loan growth related to M&A and what's going on in the market. We're continuing to do what we've done in the past, remaining active and having conversations to the extent they're available just to stay in touch with other banks in the market. And I think as you know, in the Northwest, it's been predominantly credit unions that have been the acquirer here over the last couple of years. But on that front, we certainly remain active in having the conversations. And if there was the right opportunity that we thought was the right fit, we would pursue it. Same message, no change from the past there.

Jeffrey Allen Rulis, Analyst

Got it. Sorry, one more, maybe, Tony. I wanted to get a sense of the credit situation this quarter. Are the downgrades a sign of increased aggressiveness on your part or a refreshed credit review? Or are they more about individual credits emerging or typical normalization activity? I'm curious about your perspective or the macro situation.

Anthony W. Chalfant, CRO

Yes, thanks, Jeff. I'd say it's really just identified problem credits that have been migrating down. It was somewhat coincidental that in the second quarter, we had a couple of larger deals that moved down the risk rating curve. I don't think it's a real trend at this point. As I mentioned, I believe it's more about the normalization we've been observing over the past few quarters regarding our classified and criticized credits. It simply didn’t occur this quarter. There wasn't anything particularly aggressive on our part; it was just circumstances.

Operator, Operator

Our next question comes from Matthew Clark with Piper Sandler.

Adam Kroll, Analyst

This is Adam Kroll on for Matthew Clark. So maybe to start, you have really strong growth in commitments and originations during the quarter. So I was just curious on where you see the largest opportunities for loan growth. And also, you mentioned some pause among borrowers given the uncertainty on tariffs, but I would be curious to know how that sentiment compares to April?

Bryan D. McDonald, CEO

Sure. In terms of the mix of loans we are observing, the investor presentation outlines the breakdown between categories on Slide 13. We saw a greater focus on commercial real estate in the second quarter, while the first quarter was relatively stable across the different categories. As we approach the end of the year, there seems to be an increase in commercial volume in the pipeline, along with owner-occupied loans, though there is still some commercial real estate included. This suggests a bit more balancing similar to the first quarter, but at higher levels, which is quite typical. We are actively marketing for commercial and industrial loans, owner-occupied loans, and also engaging in some non-owner business simultaneously. What was the second part of your question?

Adam Kroll, Analyst

Just maybe how the sentiment among your borrowers has changed? I know you mentioned some pause with uncertainty on tariffs, but just maybe how that changed over the quarter.

Bryan D. McDonald, CEO

Yes. We're seeing, as I mentioned, the pipeline remains strong. I think had it not been for the level of uncertainty in the market, we would see the pipeline up above where it is now. So I guess the good news is we grew the pipeline quarter-over-quarter. We're down a little bit versus last year, but not much. We're at $473 million versus $480 million. I would guess we'd be at just for reference, $520 million, $530 million, $550 million if it wasn't for the tariff activity. So that gives you a sense maybe the pipeline is off somewhere around 5% to 10% of where it would be otherwise. And out in the offices visiting with the bankers, things are just moving a little slower in some of the offices with the customers. And then in other cases, we've got bankers with a more full pipeline. So this is a little bit more intermittent than I think what we would see had we not had the disruption and some level of continued disruption in the market.

Adam Kroll, Analyst

Got it. I appreciate the color there. Maybe just switching to the margin. I was wondering if you had the spot rate on deposits at June 30 and maybe in NIM for the month of June?

Donald J. Hinson, CFO

Sure. The spot rate was 1.92% as of June 30, and our net interest margin was 3.58%. This shows that it continues to increase. June typically has slightly higher rates due to being a 30-day month compared to 31 days, but we are still observing growth in the net interest margin.

Adam Kroll, Analyst

Right. And then if I could squeeze in one more. I was just curious on the timing of when the investment securities sale and reinvestment occurred during the quarter?

Donald J. Hinson, CFO

Most occurred in June.

Operator, Operator

Our next question comes from Kelly Motta with KBW.

Unidentified Analyst, Analyst

This is Charlie on for Kelly. I've had most of mine answered, but circling back to growth quickly, you've added some new teams recently. So I'm just wondering any update on kind of the ramp-up there with production and if you think those relationships have been brought over if those teams are fully up to speed. And then a second part to that, if there's potential for further team lift-outs if you're still looking for those?

Bryan D. McDonald, CEO

We expanded our construction team recently, moving from one to four real estate construction teams this summer of 2024. The team was fully staffed at the beginning of this year, and our goal is to grow balances in that segment by around $75 million. Everything is proceeding as planned, and we are satisfied with the results. We might fall slightly short of our initial expectations due to some customers delaying starts earlier this summer, but we anticipate being close to our target. Additionally, Spokane, which we announced in January, is currently a loan production office but will become a full-service branch as we find new space and submit the application. We are very pleased with the results so far, including the loan closings, commitments, and what is in the pipeline. We are confident that the team will meet their year-end targets. Regarding new team lift-outs, with Spokane on track, we would be open to considering additional lift-outs. We have been more cautious over the past couple of years while trying to restore our profitability, so there's a balance to strike. However, we are always exploring opportunities and looking for teams that are the right fit for us to achieve our goals.

Unidentified Analyst, Analyst

Awesome. And I guess just rounding up the margin conversation, I apologize if you already hit on this, but what do you kind of expect going forward with loan yields? Do you see those continuing to drift up ex-rate cuts?

Bryan D. McDonald, CEO

Yes, please proceed, Don.

Donald J. Hinson, CFO

Yes, we do due to the repricing of just for rate loans in addition to any new loans going on at higher rates. So even with no rate cuts, we expect the 5-year index to remain fairly stable. So that's where we price a lot of our real estate loans off of. And, of course, the prime rates haven't dropped. So what is repricing is going up higher.

Bryan D. McDonald, CEO

And Charlie, I'd just add to that. If you look at Page 28 of the investor presentation, it has the repricing detail that Don just went through. So our average portfolio loan rate is 5.5%, and you can see the repricing rates and the rates of the matured loans. And then the new rate on commitments during the second quarter was 6.8% again versus the 5.5% average portfolio rate. So there is upward movement as we book new loans and get repricing.

Operator, Operator

Our next question comes from Liam Coohill with Raymond James.

Liam Joseph Coohill, Analyst

This is Liam on for David Feaster. Just actually following up on Charlie's question. It's great to see loan yields hold up so well while also originating increased volume in Q2 and looking at good growth moving forward. Understanding the competitive environment in your markets, are you seeing any competitors potentially trying to fight on price to get deals done?

Bryan D. McDonald, CEO

Yes, Liam, that's a great question. The short answer is yes, the overall market volume has decreased somewhat, which increases competition. This situation always affects the categories we pursue. However, despite the slight decline in volume, our pipeline remains strong, allowing us to find new deals to replace those we've completed. Additionally, the new teams we’ve added in the last couple of years are contributing incremental volume beyond what we would typically achieve. Without these new teams, we would likely see a larger drop in the pipeline than what we are currently experiencing. I hope this additional context is helpful.

Liam Joseph Coohill, Analyst

No, I appreciate it. And also touching on one of Adam's questions, mentioned expanding the loan office in Spokane to a full branch. Curious to hear what some of that deposit growth potential in that market might be? Like what end customers do you think might be strong depositors in that branch?

Bryan D. McDonald, CEO

Yes. Good question. It's really more about the timing we've always planned to open a full-service branch. And in the majority of the new expansion markets we've gone into, we're in an upper floor office space, but want to have full deposit-taking capabilities to be able to bank the full relationships from the business clients that we bring in. So this is really just a matter of time. We moved into some temporary space and wanted to identify permanent space before staffing for a full branch. So again, always planned, just not at that stage. In terms of the potential deposits, the relationships that we're bringing in, we would expect full deposit relationships. Right now, we're a loan production office, so we're somewhat limited, but kind of normal compensating balances, nothing particularly unique about Spokane really driven off our ability to attract new clients.

Liam Joseph Coohill, Analyst

And just last one for me. I know earlier you mentioned certain offices have been seeing more strength than others on the loan production side. I’m just curious to hear what dynamics have been driving that? Is it stronger geographies in particular areas, different end market focuses? Or has it been some of those new teams that have brought additional strength?

Bryan D. McDonald, CEO

There's no specific pattern. The economy is actually quite robust throughout the corridor on the west side of Washington, particularly along the I-5 corridor all the way to South Eugene. It's just that customer activity varies from one office to another. Our strongest markets are in King County and Portland, with King County covering the surrounding counties. These areas are significant because they constitute the largest portion of our pipeline. Additionally, we tend to gain new accounts where there is disruption in the market, such as M&A activity or changes at other institutions that may lead customers to consider switching to Heritage, especially if we have someone on our team who has worked with them before at a previous bank. This means there is a bit more emphasis on some of the new teams. However, since they don't have an existing portfolio, they are actively working in the market and reaching out to potential clients. I hope that provides some clarity.

Operator, Operator

At this time, we have no further questions. And I'll turn the call back over to Bryan McDonald for closing remarks.

Bryan D. McDonald, CEO

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. Goodbye.

Operator, Operator

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