Earnings Call Transcript - HFWA Q3 2025

Operator, Operator

Hello, everyone, and a warm welcome to the Heritage Financial 2025 Q3 Earnings Call. My name is Emily, and I'll be moderating your call today. I would now like to turn the call over to Bryan McDonald, President and Chief Executive Officer, to begin. Please go ahead.

Bryan McDonald, CEO

Thank you, Emily. Welcome and good morning to everyone who called in and 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 third quarter earnings release went out this morning premarket, and hopefully, you have had the opportunity to review it prior to the call. In addition to the earnings release, 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. As a reminder, during this call, we may make forward-looking statements, which are subject to economic and other factors. Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within the earnings release and the investor presentation. Improving net interest margin and tight controls on noninterest expense growth continue to incrementally drive earnings higher in the third quarter. On an adjusted basis, earnings per share was up 5.7% versus last quarter and up 24.4% versus the third quarter of 2024. And on the same adjusted basis, our ROAA improved to 1.11% versus 0.87% in the third quarter of 2024. We are excited about the pending merger with Olympic Bancorp. Their addition to the Heritage franchise will add to the profitability of our operations and better position our company for growth in the Puget Sound market. We'll now move to Don, who will take a few minutes to cover our financial results.

Donald Hinson, CFO

Thank you, Bryan. I will be discussing the main factors impacting our performance for Q3. As I review our financial results, all comparisons will be with the second quarter of 2025 unless stated otherwise. Starting with the balance sheet, total loan balances were relatively stable in Q3, with a decrease of $5.7 million. Although loan originations rose from Q2, payoffs and prepayments also increased in Q3, while utilization rates fell. Yields in our loan portfolio were 5.53%, up by 3 basis points compared to Q2, primarily due to new loans being issued at higher rates and adjustable rate loans being repriced higher. Bryan McDonald will provide an update on loan production and yields shortly. Total deposits rose by $73 million in Q3, with noninterest-bearing deposits increasing by $33.7 million. This increase in total deposits took into account a $31.4 million decrease in certificates of deposit, mostly from a $25 million decline in brokered CDs. The cost of interest-bearing deposits fell to 1.89% from 1.94% in the previous quarter. Following the rate cut in September, we anticipate further declines in the cost of deposits. Investment balances decreased by $33 million, mainly due to expected principal cash flows. To maintain capital for the upcoming acquisition, we ceased loss trade activity in Q3 and did not purchase any securities. Moving to the income statement, net interest income increased by $2.4 million, or 4.3%, from the previous quarter, largely due to a higher net interest margin, which rose to 3.64% from 3.51% in the prior quarter and 3.30% in the third quarter of 2024. We recognized a provision for credit losses of $1.8 million, up from $956,000 in the prior quarter, primarily due to an increase in the weighted average life of the construction loan portfolio. New construction loans increased both the portfolio's average life and reduced utilization rates. Net charge-offs remain very low. Tony will share more information on credit quality metrics shortly. Noninterest expense increased by $530,000 from the prior quarter, mainly due to higher compensation and benefits expenses along with increased professional services. We recognized $635,000 in merger-related expenses in Q3, primarily in the professional services category. Compensation and benefits expenses rose significantly due to higher incentive compensation accruals. Finally, regarding capital, all of our regulatory capital ratios remain securely above well-capitalized thresholds, with our TCE ratio at 9.8%, up from 9.4% in the prior quarter. In keeping with our lack of activity in loss trades on investments, we also did not engage in stock buybacks during Q3 and are unlikely to resume stock buybacks for the rest of the calendar year. Now, I will hand the call over to Tony for an update on our credit quality.

Tony Chalfant, CRO

Thank you, Don. Through the first 3 quarters of the year, I'm pleased to report that credit quality remains strong and stable. Nonaccrual loans totaled $17.6 million at quarter end, and we do not hold any OREO. This represents 0.37% of total loans and compares to 0.21% at the end of the second quarter. The largest addition during the quarter came from 2 loans totaling $6.7 million that are primarily secured by a townhome construction project. That project is nearly complete and the unit should be listed for sale before year-end. There is currently no loss expected on these loans and the nonaccrual decision was primarily tied to the delinquency status. Also within our nonaccrual loan portfolio, we have just over $2.8 million in government guarantees. Nonperforming loans increased modestly from 0.39% of total loans at the end of the second quarter to the current level of 0.44%. This increase was primarily tied to the previously mentioned increase to nonaccrual loans. Criticized loans moved lower during the quarter. These loans rated special mention or substandard totaled just under $194.5 million at quarter end, declining by just over $19 million during the quarter. Substandard and special mention loans were down by 5% and 12%, respectively, during the quarter from a combination of payoffs and upgrades. At 2% of total loans, substandard loans remain at a manageable level and in line with our longer-term historical performance. Page 19 in our investor presentation provides more detail on the composition of our criticized loans and reflects the stability we've seen in this portfolio over the past 2 years. During the quarter, we experienced total charge-offs of $374,000 that were split evenly between consumer and commercial loans. The losses were partially offset by $256,000 in recoveries leading to net charge-offs of $118,000 for the quarter. For the first 9 months of the year, net charge-offs remained low at $911,000. 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 20 of the investor presentation shows our history of low credit losses and how we compare favorably to our peer group. We are pleased with the strength and stability of our credit metrics for both the quarter and through the first 9 months of the year. While we are closely watching the increase in our nonperforming loans, it is important to note they remain at a low level when compared to our historical trends. While there has been some economic volatility this year, we have yet to see any material impact on our credit quality. We remain confident that our consistent and disciplined approach to credit underwriting will serve us well should the economy show any material deterioration in the coming quarters. I'll now turn the call over to Bryan for an update on our production.

Bryan McDonald, CEO

Thanks, Tony. I'm going to provide detail on our third quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $317 million in new loan commitments, up from $248 million last quarter and up from $253 million closed in the third quarter of 2024. 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 $511 million, up from $473 million last quarter and up modestly from $491 million at the end of the third quarter of 2024. As we look ahead to the fourth quarter, we are estimating new commercial team loan commitments of $320 million, which is very similar to Q3 levels. As anticipated, loan balances were fairly flat quarter-over-quarter with a $6 million decline in the quarter. Although total loan production was up $81 million or 30% 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 $124 million higher than last year, and net advances on loans have swung from a positive $142 million last year to a negative $75 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 fourth quarter, we expect loan balances to remain near Q3 levels then resume growth to more normal levels in 2026 as loan payoffs moderate, and the net advances moved back to a positive position. Deposits increased $73 million during the quarter and are up $173 million year-to-date. The deposit pipeline ended the quarter at $149 million compared to $132 million in the second quarter. And average balances on new accounts opened during the quarter are estimated at $40 million compared to $72 million in the second quarter. Moving to interest rates. Our average third quarter interest rate for new commercial loans was 6.67%, which is up 12 basis points from the 6.55% average for last quarter. In addition, the third quarter rate for all new loans was 6.71%, up 13 basis points from 6.58% last quarter. In closing, as mentioned earlier, we are pleased with our solid performance in the third quarter. Deposit growth has allowed us to pay down borrowings and broker deposits while our loans have continued to reprice upward. These factors drove our net interest income up $2.4 million versus last quarter and $4.4 million versus the third quarter of 2024. The combination with Olympic Bancorp and its subsidiary, Kitsap Bank, will add to this positive momentum in a significant way. We look forward to having the exceptional bankers of Kitsap join the Heritage Bank family and are excited about what we can accomplish together. Overall, we believe we are well positioned to navigate what is ahead and to take advantage of various opportunities to continue to grow the bank. With that said, Emily, we can now open the line for questions from call attendees.

Operator, Operator

Our first question today comes from Matthew Clark with Piper Sandler.

Adam Kroll, Analyst

This is Adam Kroll on for Matthew Clark. Yes. So maybe just starting off on the margin. I was wondering if you had the spot cost of deposits at September 30 and maybe the NIM for the month of September?

Donald Hinson, CFO

Sure, Adam. The spot rate on cost deposits was 1.87% for interest-bearing accounts, compared to 1.89% for the quarter, while the total cost deposits stood at 1.35%. The net interest margin for September was 3.66%, up from 3.64% for the quarter.

Adam Kroll, Analyst

Got it. That's super helpful. And then just on deposit costs. I guess how much opportunity do you still see to reduce rates on the nonmaturity side?

Tony Chalfant, CRO

We have close to approximately $1 billion in exception price that is currently costing us nearly 3%. As rates are reduced, we will work to lower those costs over time. It's a gradual process that doesn't happen immediately, but we have made some progress. Additionally, when we bring on new accounts, they tend to have rates higher than the overall portfolio, which lessens the impact of rate cuts. However, I do expect we will be able to continue reducing those costs over time.

Adam Kroll, Analyst

Got it. I appreciate the color there. And then maybe just one last one for me is I was wondering if you could just expand on how you're thinking about organic loan growth in '26? And do you have any visibility into payoffs and when they might normalize lower?

Bryan McDonald, CEO

Sure, Adam. We expect to return to our traditional growth range of mid- to high single digits next year. During the second quarter call, I mentioned that we anticipated growth in the fourth quarter, and now we’re expecting several larger payoffs at that time. Therefore, we forecast being flat again. There are two key factors at play here. One is the payoff of some construction loans we’ve had over the past few years that are maturing. You can see this reflected on Page 14 of the investor presentation, which shows the utilization rates of construction loans as they transition to permanent loans and get paid off. Additionally, many of our new bookings in the last few quarters have been in the construction segment, which has led to lower fundings. If you review the changes in loans for the quarter, our net advances on construction loans, as well as across all lines, are lower this year compared to last year. We expect that as we enter 2026 and work through the remaining payoffs, we will experience positive net advances on those loans, providing us with a bit of a tailwind compared to the headwind we faced this year. Our production remains strong, exceeding $300 million last quarter, and we anticipate similar results in the fourth quarter. However, projecting into 2026 is challenging because our pipeline is generally accurate only up to 90 days ahead. It’s difficult to predict loan demand for 2026, but I have noticed a strengthening trend since the summer. At this time, I don't see any factors that would cause a drop in loan demand or a reduction in our pipeline, aside from the usual uncertainties. We are currently observing a trend moving in the opposite direction.

Operator, Operator

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

Jeff Rulis, Analyst

Maybe staying on the payoff front, just a follow-up. Any of that kind of managed by you or encouraged balance reductions for credit-related reasons?

Bryan McDonald, CEO

Yes, Jeff, I would say the kind of the change in the fourth quarter is some several larger payoffs that are for adversely classified credits, not necessarily a circumstance where we're working them out of the bank, but ones where the customers have decided to sell the assets and pay it off. So that's the difference versus last quarter. We've got a few in that bucket and then one additional construction loan that's going to pay off in Q4. We're expecting Q4 versus previously we thought it push into '26. So that's the change for Q3. Not a huge number of loans, but a couple of chunky ones in there.

Jeff Rulis, Analyst

Sure. That's helpful. I wanted to discuss the success we had with deposits this quarter, indicating solid core deposit growth. Are seasonal factors influencing this, or is it primarily due to the team's execution, or possibly a combination of both? I’m just trying to understand this better.

Bryan McDonald, CEO

Yes, it is a bit of both. Third quarter, traditionally our strongest deposit growth quarter during the year, and that was the case last year, and we saw it this year. The years previously were hard to see it, of course, because of all the rate changes and the outflow of excess deposits. But yes, seasonal increase. And then we've had good additions from the new account activity side. And so those are driving the balances as well as some accumulation in customer accounts, again, more related to that seasonality.

Jeff Rulis, Analyst

Got you. And then connected maybe, Don, on the margin, I guess, it sounds as if those deposit costs or spot rate and margin trending well. Is there a bit of a carryover or a declining benefit from the loss trades. I guess anything you give puts and takes on margin, particularly in light of cuts as well, rate cuts? Where would you sort of position the margin ahead?

Donald Hinson, CFO

Yes. I don't think we're going to get the margin growth based off the rate cut we had in mid-September, which we didn't feel the full effect of or experience the full effect of and kind of expecting one next week. I think we're going to continue to get, again, help on the deposit side. But I think the loan yields are going to be fairly flattish this quarter. We're going to continue to be able to reprice adjustable rate loans higher and new loans going on will be higher. But those rate cuts when we have, I think, it's 22%, 23% fully floating that also impacts it. So having flattish loan yields for the quarter and maybe some help on the deposit side, I think we might continue to see some NIM improvement, but it will be muted compared to last quarter.

Operator, Operator

Our next question comes from Liam Coohill with Raymond James.

Liam Coohill, Analyst

Liam On for David. So we've talked a lot about the deposit success in the quarter and I was curious, how has competition been trending in your markets, especially with a lot of banks targeting high levels of loan growth. Where are you seeing the most opportunity for gathering those deposits even in a seasonally stronger quarter?

Bryan McDonald, CEO

Yes, Liam, really, it's the same strategy we've deployed in the past going after the operating relationships, accounts that look for strong servicing. Don mentioned in his deposit comments that some of the new relationships we're bringing on have a little higher average cost than the bank's average. And that's because for those excess deposits to the extent that customers are shopping between a few banks, we're having to pay up on those excess deposits, maybe a little bit more so than we are within the portfolio on average. But then, of course, we're getting strong demand balances along the way. So we still see competition in our market, strong pricing competition on deposits. It's kind of varied from one local geography to another in terms of who the players are that are being particularly aggressive with deposits. So that continues to be a factor. But if you're going after the operating relationships, it's a different driver than price on that piece. So that's the key.

Liam Coohill, Analyst

I appreciate that. And on the acquisition of Olympic, how has progress in the pending deal been trending? And what are the most pressing priorities from your view post deal approval and integration?

Bryan McDonald, CEO

Yes, Liam, everything is progressing right as planned. We have a project plan and timeline and everything is going smoothly. Not seeing anything at this point that would change our estimated closing date beginning of Q1; we're on track for that. And then, of course, coordinating closely with the Olympic team to make sure everything goes smoothly, and that's also been going very well. So nothing at this point of concern, just going just as we had anticipated.

Liam Coohill, Analyst

Great. And then last one for me. I mean asset quality remains pretty strong broadly, and it's great to hear that that credit migration is likely going to be resolved without loss in 4Q. With classified down quarter-over-quarter, is there anything you're watching more closely moving forward? Or is all seemingly quiet?

Tony Chalfant, CRO

Yes, Liam, that's a good question. The impact from some economic volatility has been somewhat uneven across the portfolio, but nothing major. We are considering a few loans from relationships that have been slightly affected by this. Generally, it's just the usual fluctuations in the classified and criticized categories that we normally observe. There aren't any specific trends we are monitoring. As Bryan mentioned, we do have some positive momentum in the substandard category that is expected to materialize in the fourth quarter. Currently, the loans in our nonperforming category do not appear to present significant loss potential.

Operator, Operator

Our next question comes from Jackson Laurent with Stephens.

Jackson Laurent, Analyst

This is Jackson on for Andrew Terrell. If I could just hit on expenses first, and I apologize if I missed it. Adjusting for the merger costs in the quarter, expenses were right at the bottom end of the previously guided $41 million to $42 million expense guide. Just wondering if that's a good run rate that we should be looking for going forward?

Donald Hinson, CFO

Sure, I'll take that, Bryan. The one impact to this quarter that we haven't had is the state raised their revenue tax rate and that's going to impact us by about $300,000 per quarter. So other than that, I expect it to be pretty similar. It fluctuates some, right? But still I would say in the low 41s core, and then we also have this $300,000 that we'll be dealing with. So it may pump up more into the mid-41s as a result. But that I think it still is a pretty good run rate overall. And we'll still have some acquisition-related costs, which I'm not sure exactly when they're all going to hit. We're going to have some again this quarter, but there will also be some next quarter and, of course, over the conversion post-acquisition.

Jackson Laurent, Analyst

Got it. That's helpful. And then just last one for me. I know the primary focus has been on closing the current pending deal, integrating the franchise, but it seems like the M&A space has been heating up a little bit. Just wondering how you guys are thinking about M&A post-deal close? And just honestly, how conversations have been trending recently?

Bryan McDonald, CEO

Yes. Obviously, our first priority is to work through the transaction with Olympic and get that closed. We're anticipating early Q1 for the closure. We're continuing our discussions just like we always have. And if there was an opportunity that came up, we would consider it. So again, focus is on the Olympic deal and getting it closed. But looking ahead to next year, if the right opportunity came along, we'd certainly be open to taking a look.

Operator, Operator

We have not received any further questions, so I will turn the call back over to Bryan McDonald for any closing comments.

Bryan McDonald, CEO

Thanks, Emily. If there are no more questions, then we'll wrap up this quarter's earnings call. We thank you for your time, your support, and your interest in our ongoing performance. We look forward to talking to many of you in the coming weeks. Goodbye.

Operator, Operator

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