Earnings Call Transcript - HFWA Q1 2025

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, President of Heritage Financial. Attending with me are Jeffrey Deuel, CEO; Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer. Our first quarter earnings release went out this morning premarket, and hopefully, you have had the opportunity to review it prior to the call. We have also posted an updated first quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity, and credit quality. We will reference the presentation during this call. We are pleased with our operating results for the first quarter, including strong deposit growth, reduced borrowing levels, and margin expansion. We are optimistic the combination of our core balance sheet growth and prudent risk management will continue to benefit our core profitability as we progress through 2025. We will now move to Don, who will take a few minutes to cover our financial results.

Don Hinson, CFO

Thank you, Bryan. I'll be reviewing some of the main drivers of our performance for Q1. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the fourth quarter of 2024. Starting with the balance sheet. Although loan production was similar to the first quarter of 2024, total loan balances decreased $37 million in Q1 due to elevated payoffs and prepayments. Yields in the loan portfolio were 5.45%, which was 2 basis points lower than Q4. This was due primarily to the 50 basis point reduction in the Fed funds rate in Q4, Q1 incurring the full impact of these cuts. Bryan McDonald will have an update on loan production and yield in a few minutes. We had strong deposit growth in Q1 and 95% of this growth was in non-mature deposits. Total deposits increased $160.7 million in the quarter, with the majority of the growth in money market accounts. Unlike the past several quarters, we did not experience much growth in CD balances with the percentage of CDs to total deposits decreasing during the quarter. The movement of balances from non-interest-bearing accounts to interest-bearing accounts shows that customers are continuing to invest excess funds into higher-yielding accounts. The cost of interest-bearing deposits decreased to 1.92% in Q1 from 1.98% in the prior quarter. We expect to continue to see some further decreases in the cost of total deposits due to the repricing of CDs. However, we don't expect decreases in the cost of interest-bearing non-maturity deposits absent further rate cuts by the Fed. Investment balances decreased $53.8 million, partially due to a loss trade executed during the quarter. A pretax loss of $3.9 million was recognized on the sale of $61 million of securities. These sales were part of our strategic repositioning of our balance sheet in which a portion of the proceeds was reinvested in $28 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 decreased slightly from the prior quarter due to fewer days in Q1 compared to the prior quarter. The net interest margin increased to 3.44% for Q1 from 3.36% in the prior quarter, due primarily to decreases in the cost of both deposits and borrowings. We recognized a provision for credit losses in the amount of $51,000 during the quarter. This small provision expense was due to the decrease in loan balances during the quarter, along with continuing low levels of charge-offs. Tony will have additional information on credit quality metrics in a few moments. Non-interest expense increased $1.8 million from the prior quarter due mostly to higher benefit costs and payroll taxes. We continue to guide in the $41 million to $42 million range for quarterly non-interest 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 9.3%, up from 9% in the prior quarter. Our strong capital ratios allow us to be active in loss trades on investments and stock buybacks. Although we did not repurchase any shares under the stock repurchase plan in Q1, we may in the future depending on market conditions and other capital needs. We still have 990,000 shares available for repurchase under the current repurchase plan as of the end of Q1. I will now pass the call to Tony, who will have an update on our credit quality.

Tony Chalfant, Chief Credit Officer

Thank you, Don. Through the first quarter, credit quality remained strong and stable. Non-accrual loans totaled just over $4.4 million at quarter end, and we do not hold any OREO. This represents 0.09% of total loans and compares to 0.08% at the end of 2024 and 0.10% at the end of 2023. The increase in the first quarter was a modest $359,000. Page 18 of the investor presentation reflects the stability in our non-accrual loans over the past three years. Non-performing loans improved from 0.11% of total loans at year-end to the current level of 0.09%. This category now includes only non-accrual loans. We had one C&I relationship that was over 90 days past due at year-end and still accruing that was paid off during the quarter. Criticized loans, those rated special mention and substandard, totaled just over $178 million at quarter end, declining by $1 million during the quarter. Loans in the more severe substandard category were down by 5.7% or $3.9 million. Substandard loans represented 1.4% of total loans at quarter end, consistent with year-end 2024 and lower than the 1.6% we experienced at year-end 2022 and 2023. The credit quality of our office loan portfolio has remained stable over the last 12 months. This loan segment represents $572 million or 12% of total loans, and 52% of these loans by dollar amount are owner-occupied. The average loan size is $1.1 million. They are diversified by geographic location, and we have little exposure to the core downtown markets. Criticized office loans totaled just under $14.5 million, representing 2.5% of total office loans. Page 17 of the investor presentation provides more detailed information about our office loan portfolio. During the quarter, we experienced total charge-offs of $376,000 that were split evenly between commercial and consumer portfolios. The losses were offset by $77,000 in recoveries, leading to net charge-offs of $299,000 for the quarter. 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. While we are pleased with the stability in our credit metrics through the first quarter, we are aware of the emerging risks in the economy. We will be closely watching developments around tariffs, changes in federal funding, and other issues that could have an impact on our credit quality. We remain confident that our consistent and disciplined approach to credit underwriting and portfolio management will serve us well in this period of economic uncertainty. 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 first quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $183 million in new loan commitments, down from $316 million last quarter and up from $133 million closed in the first 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 first quarter at $460 million, up modestly from $452 million last quarter and up from $409 million at the end of the first quarter of 2024. Tariffs and other emerging economic uncertainty have caused some of our customers to suspend capital plans, but we have yet to see it substantially impact the loan pipeline. We are watching this closely and believe if the uncertainty persists, more customers may pause their spending. Loans declined for the quarter by $37 million due to elevated payoffs and prepaid loans. In addition, the mix of loans closed during the quarter resulted in lower outstanding balances. Please see Slides 14 and 16 of the investor presentation for further detail on the change in loans during the quarter. Deposits increased $161 million during the quarter as new business acquisition remains strong. Balances on new accounts opened in the fourth quarter continue to fully fund, and seasonal outflows were moderate compared to our typical first quarter. The deposit pipeline ended the quarter at $165 million compared to $141 million last quarter, and the average balance on new deposit accounts opened during the quarter is estimated at $54 million compared to $121 million in the fourth quarter. Moving on to interest rates. Our average first quarter interest rate for new commercial loans was 6.83%, which is up 20 basis points from the 6.63% average for last quarter. In addition, the first quarter rate for all new loans was 6.89%, up 23 basis points from 6.66% last quarter. In closing, as mentioned earlier, we are pleased with our solid performance in the first quarter. It was a strong quarter for deposit growth and the third consecutive quarter of net interest margin improvement. 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 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

Hello, everyone, and welcome to the Heritage Financial Q1 Earnings Call. My name is Emily, and I will be coordinating your call today. After the presentation, you will have the opportunity to ask questions. I will now hand it over to Bryan McDonald, President and CEO. Please go ahead, Bryan.

Jeff Rulis, Analyst

Thanks, good morning. Congratulations on the transition, Jeff. I really appreciate your authentic approach. I’m looking to convince the rest of your team to bring you down to Scottsdale in a couple of weeks. In terms of your insights on Heritage and its standing in the Northwest among independent banks, especially given the ongoing mergers and acquisitions, I’m interested in your views. The information on Slide 11 about your successful team acquisitions is quite revealing. So, could you share your perspective on how the bank is positioned?

Jeffery Deuel, CEO, Heritage Financial

I would say, Jeff, that our position is pretty good. The way we look at it is we have a plan for 2025 and going into '26 with some very specific goals. And I think it's our desire to keep working towards those goals with the idea that we're going to continue to take advantage of opportunities with teams around the footprint. And if there is potential M&A, we've always said that we're ready for that as well. So there are fewer banks around us. And in some cases, the smaller banks that maybe we didn't take action on are probably mostly because it wouldn't have done much for us in terms of developing our own organization. But there are still some attractive banks in our footprint that we'd love to join forces with at some point. But in the meantime, I think we have a pretty solid balance sheet. And as Bryan said, our pipeline is looking pretty good, and our deposits are starting to fall back in line. I feel like we're in a pretty good position and I feel good handling the team, the responsibility going forward. They're all veterans. And I would say overall, I think we're in a good spot.

Jeff Rulis, Analyst

Got it. And maybe a question for all, just the team in you spoke that you picked up and maybe kind of what led to that move? And any sort of color on that pickup?

Bryan McDonald, CEO

Sure. Jeff, this is Bryan. It's a group from a larger regional bank. They had made the determination that they wanted to make a move and sought us out. We had some dialogue over a period of time, just assessing the fit of the individuals and the type of customer base to make sure it was a good fit for Heritage. And then, of course, the market as well assessing whether there was a spot for Heritage in that market. After going through that process, the answers were yes, yes, and yes, and we went ahead and moved forward. We have three bankers there in Spokane. It's a little smaller team than what we've done in the past, supporting it in part from other teams across the bank. This ties into Jeff's comments earlier. We've got financial goals we're looking to hit here in 2025. The smaller size of the team is reflective of us just trying to balance taking advantage of the opportunity to bring in some great talent, but at the same time, trying to manage the expenses so we can still hit our 2025 numbers.

Jeff Rulis, Analyst

Great. And maybe one last one. I think Don touched on the buyback or lack thereof in the first quarter. You were active in the fourth quarter, and it sounds like you're kind of balancing that decision with the restructuring as well. Anything to comment? Was there anything precluding you in the first quarter from that? Or was that just a quarter-by-quarter decision? I thought I'd check in on the buyback.

Don Hinson, CFO

Yeah, it's a quarter-by-quarter decision. Our stock price was up also in last quarter, so it made it somewhat less attractive. We kind of took a little bit of a break, I guess you might say we were pretty active last year. Stock price was up in the 24, 25 range, so it was just a decision we made last quarter to hold on to some capital. But it wouldn't surprise me at these levels if we are back, active sometime this quarter.

Jackson Laurent, Analyst

Good morning. This is Jackson Laurent on for Andrew Terrell. If I could just start off on the margin, and I apologize if I missed it, but could you provide the spot cost on total deposits at 3.31 and then the NIM in the month of March, if you could as well?

Don Hinson, CFO

The NIM for March was 3.45%. The cost of interest-bearing deposits for March was 1.92%, which is roughly the same for the quarter, while the spot rate is actually 1.94%. This variation is largely due to the mix at the end of the quarter. We are not increasing our rates, which will cause some fluctuations. I don't anticipate significant changes to non-maturity interest-bearing deposits until there is a Fed cut. However, I do believe our cost of CDs will decrease as new rates are lower than the current ones, particularly with brokered CDs, where we have $110 million maturing this month at just over 5, and we expect to reduce that by about 100 basis points. This is why we see ongoing opportunities to lower overall deposit costs.

Jackson Laurent, Analyst

Understood. Appreciate the color.

Don Hinson, CFO

Yeah, I will say one more thing on the margin. We continue to see our loan yields. We expect our loan yields to continue to increase. I know it was down quarter-over-quarter, but that was because of the rate cuts in Q4, and we're kind of getting the full impact of that this quarter. The loan yields actually increased from January to March by 3 basis points. So without rate cuts, the new loans going on at higher rates and what's coming off at lower rates will also continue to help us. The Spokane team was added pretty early in the quarter. Almost all of it is baked in already. If we add personnel there or add additional space of some kind on the occupancy side, that could add more. We're not expecting any significant increases due to that.

Bryan McDonald, CEO

I was just going to say they started right at the end of January. So same comment Don made. The majority of the costs are already in the Q1 numbers.

David Feaster, Analyst

Good morning everyone. I'm filling in for David. I have a quick question about the new loan commitments. It's encouraging to see them being fairly broad-based, especially as we approach the stronger seasonal quarters. Where do you see the greatest opportunity for growth given the current breadth of these commitments?

Bryan McDonald, CEO

Yeah. If you look at Page 13 in the investor presentation, it has the breakout of commercial real estate and C&I and construction. Really, all of last year, with the exception of the fourth quarter, it was C&I that was leading it, and then it was pretty balanced in Q1. That's really the mix we're trying to maintain. We've had an oversized emphasis on deposit sales and expanding our calling efforts on deposit-rich clients, which is part of the reason you see the high percentage of C&I last year. Again, the bank has always pursued C&I, but we've had a really strong focus on deposits seeking balance sheet growth. So I'm expecting the same type of mix we saw last year between C&I and real estate being the two primary categories.

David Feaster, Analyst

Great. And actually touching on the deposit side, the growth was really robust in the quarter. And I know you mentioned that it was both between new and existing accounts. Have any customers in particular been driving that growth? And where are you seeing the most opportunity today on that front?

Bryan McDonald, CEO

Well, really, if you look at the growth, a lot of it in the last couple of quarters has come from expansion of existing relationships in addition to new relationships. I think what was really unusual about the first quarter, particularly as you compare it to last year, was the composition. As Don mentioned in his comments, really the growth in CDs was nominal during Q1 2025 versus last year. It was over $80 million worth of CD growth, and the deposit growth for Q1 last year was actually a negative $67 million. So the first quarter typically is a quarter where deposits would decline really, typically through tax payments, and then we would typically seasonally see it stabilize growth through the summer and typically through the end of the year. We've just had a lot of new accounts added to the bank, and then we've also seen expansion of existing account relationships. I think some of that in Q1 was influenced by what's going on in the market, perhaps some customers bringing cash back to the bank rather than deploying it into the market. But we're pleased with it and looking at the new accounts; I guess to answer that piece of it. Most of the new relationships come from other banks that are going through some sort of disruption in the market. Sometimes that takes two or three years of calling before there's a situation where we really get a shot at it. We've continued to get some good opportunities through. The fourth quarter last year was a significant quarter, and some of those continued to fund in Q1, making Q1 again a strong quarter.

David Feaster, Analyst

No, that's helpful. Thank you. And I know you mentioned the volatility in the markets. Given the economic backdrop, it's really impressive to see credit metrics remaining strong. Just wondering, is there anything you're watching more closely? And has your approach to underwriting or managing credit adapted at all?

Bryan McDonald, CEO

Yes, that's a good question. Tony, do you want to take that one?

Tony Chalfant, Chief Credit Officer

Sure, yeah. No, clearly, we're looking at it closely right now. It's a little too early to see any direct impact from all the changes around tariffs and federal funding and things like that. What we're really focused on is just putting infrastructure in place to manage that. We have a cross-departmental team that we've put together pulling data from our database, and we're trying to cross-reference it with those industries we think would be most impacted, really starting to dig into those larger exposures. It's going to start with client communication because they're the ones with the best insight into what's happening with their business models, and that's where we're starting. But it will continue to expand. I'm expecting some impact from it, but it's a little too early to say. For the most part, it's a wait-and-see attitude, but we're making sure we react, but we don't overreact right now.

David Feaster, Analyst

Great. I appreciate the color. I’ll step back. Thanks again, guys.

Kelly Motta, Analyst

Good afternoon. Thank you for the question. I’m curious, given the recent changes, particularly over the last month, if the increasing economic uncertainty has prompted you to adjust your outlook for the year, or if your expectations for loan growth and credit fluctuations have remained consistent.

Bryan McDonald, CEO

Yeah. Thanks, Kelly. Good morning. Looking at the current pipeline, which again was above where we ended the year and above last year, for the second quarter, we're estimating an annualized growth rate of kind of in that 5% to 8% range. So we feel like we have good visibility near term. In general, the kind of loan activity and pipeline levels, loan activity, and our banker activity levels are stronger coming into this year than they were last year. And last year was an excellent year for loan growth. We did have a decline in the quarter. If you look at Page 16 in the investor presentation, it gives you a good sense of what was driving that. The originated loans and the outstanding balances were quite a bit lower again just due to the mix of loans, and then prepayments and payoffs, you can see that was $127 million for the first quarter, which is significantly above the run rate for last year. The other big one is the net advances in payments; that was actually a negative number. We did have a lot of construction loans that fully funded out last year. This is in 2024 from commitments booked in the prior year. We went into the year expecting a bit of a headwind related to construction loans paying off, which is obviously what we want to have happen. But at the same time, a stronger pipeline than we had last year. Again, last year was an excellent year of loan growth. So I think the backdrop coming into the year is stronger than it was last year. The uncertainty is really hard to gauge. We're just watching the credit side and the pipeline closely, with lots of interaction with the clients, but just too soon to read. So again, for Q2, we're looking at kind of annualized growth in the 5% to 8% range. The pipeline is there. Typically, production would build into the second, third, and fourth quarters, but hard to tell how much of the pipeline falls out if this uncertainty continues.

Kelly Motta, Analyst

Got it. That's really helpful. I appreciate all the commentary and color on the new team in Spokane added this quarter. It sounds like it's a smaller team than normal. I'm wondering if there are any areas you may be looking to add density within your current footprint, or fill out as there's some additional disruption out west. So I'm wondering where geographically you might see opportunities for Heritage to add talent? Thank you.

Bryan McDonald, CEO

Yeah. We're really open to adding talent anywhere within the footprint if we have the opportunity to hire high-quality bankers. Most likely, it would be kind of a one or two-higher approach, most likely a replacement for another position that vacated either in that market or another market where we would then move the FTE to a different market if we were able to find a highly talented banker. Spokane is a smaller team, but a lot of that is on the support side. The production team is a little bit smaller than what we would have started with in the past few teams. But again, that's really us trying to take advantage of the opportunity to bring on the talent, but still maintain a tight focus on expenses and hitting our 2025 targets. I think we're doing a good job of balancing those two items.

Adam Butler, Analyst

Hey, everyone. This is Adam on for Matthew Clark. Hope you’re doing well.

Bryan McDonald, CEO

Good morning, Adam.

Adam Butler, Analyst

Good morning. Just my first question is around the loan growth side of things. I know that you commented that 2Q annualized growth is looking and trending towards the 5% to 8% range. But, and you also touched on the degree of payoff and paydown activity that kind of inhibited growth this past quarter. I know it's hard to predict, but I was just curious if I could get some commentary on how those payoff and paydown trends are going thus far this quarter? And how you think that could inhibit growth based on your pipeline?

Bryan McDonald, CEO

Yeah. In the second quarter, we've incorporated what our expectations are for payoffs in that annualized 5% to 8% range. Since it's relatively near term, looking at the pipeline and payoffs, we feel like that's a reasonable number. Of course, the payoffs could be higher, or deals could move a little a month here or there, and that may impact the final number. In Q1 the difference was a few business sales that we weren't expecting. We had some construction loan payoffs, but we also had a couple of customers that sold businesses and paid off loans. We had another circumstance where a customer had a loan reprice from the mid-3 range up into the high 6s, and they opted to pay it off with cash. So that was not, obviously, not expected either. As we enter Q3 and Q4, we are expecting more construction loan payoffs there. But again, looking at the pipeline and where it typically moves, should be enough to offset that and come back to that mid to high single-digit overall growth. The unknown is how much the market uncertainty is going to draw back from what we would traditionally do in those quarters. We’re just watching the pipeline very closely.

Don Hinson, CFO

The restructuring actually occurred in March. We didn't see a full impact of it as far as on the yield side for the quarter. But we'll continue to look at that. We kind of make these decisions on a quarter-by-quarter basis. The last couple of quarters, we've basically been somewhat similar on the amount. There's a chance we could up that some. But right now, we do kind of want to continue to optimize our balance sheet as best we can, and this is a lever that we can use. So I would expect to continue to have it at some level.

Operator, Operator

Thank you, everyone, for joining us today. The replay of this call will be available until Thursday, May 1, and can be accessed dialing the U.S. number, 929-458-6194 with the access code 606836. Thank you for your participation. You may now disconnect your lines.