Earnings Call Transcript - HFWA Q1 2024

Operator, Operator

Hello, and welcome to Heritage Financial Corporation's First Quarter 2024 Earnings Call. My name is Lydia, and I will be your operator today. I will now hand you over to Jeff Deuel to begin. Please go ahead.

Jeffrey J. Deuel, CEO

Thank you, Lydia. Welcome and good morning to everyone who called in and those who may listen later. This is Jeff Deuel, CEO of Heritage Financial. Attending with me are Bryan McDonald, President and Chief Operating Officer; 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 deposits, loan portfolio, liquidity, and credit quality. We will reference this presentation during the call. Please refer to the forward-looking statements in the press release. Although there was some noise in the quarter, we are pleased to report a solid core performance, including active balance sheet management and expense management activities to reduce noninterest expense. We continue to see pressure on deposit pricing in Q1, and we expect to see that continue for the near term. Deposit balances declined modestly in Q1, and the mix of deposits continues to partially shift to higher rate products. Loan growth was strong in Q1, running at an 8.4% annualized rate. Credit quality remains strong, resulting from our long-term practice of actively managing the loan portfolio. We have ample liquidity, a low loan-to-deposit ratio, and a solid capital base. Going forward, we will keep a sharp eye on expenses while we focus on growing loans and deposits.

Donald Hinson, CFO

Thank you, Jeff. I will 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 2023. I want to start by covering some actions that significantly impacted earnings for Q1, and are expected to help protect future earnings. First, we repositioned a portion of our investment portfolio, which resulted in a pretax loss of $10 million during Q1, which is similar to the loss recognized in Q4. We sold $144 million of securities with a weighted average yield of 2.37% and purchased $33 million of securities yielding 6.05%. Including the yield on cash not reinvested at quarter end, we are expecting an annualized net interest income pickup of about $4.6 million from these transactions, resulting in an earn-back period of approximately 2.5 years. Unlike the trade in Q4, where we reinvested substantially all of the proceeds, we intend to use a portion of this quarter's proceeds for other cash needs, such as the BTFP debt that matures in early May. Second, we incurred certain costs related to expense management measures in order to lower expenses in future periods. For Q1, these primarily included severance costs of $1.1 million due to reduction in staffing levels, which we mentioned during our previous earnings call in January. These costs, in aggregate with expense management costs incurred in Q4, are expected to improve the annualized expense run rate by $5.3 million. Please see Page 6 of the investor presentation for more information on these actions. Moving on to the balance sheet, loan growth was strong in Q1, as mentioned by Jeff, increasing $92.5 million for the quarter. Most of this growth occurred in the latter portion of the quarter, and the benefits won't be fully realized until Q2. Yields in the loan portfolio were 5.41% for the quarter, which was 6 basis points higher than Q4. Bryan McDonald will have an update on loan production and yields in a few minutes. Total deposits decreased $67.5 million during the quarter. This was due to a decrease of $154 million in non-maturity deposits, approximately half of which was due to declines in noninterest-bearing deposits, partially offset by an increase of $87 million in CD balances. Customers continue to take advantage of the higher rate environment by lowering their excess balances and lower paying non-maturity deposit accounts. These factors contributed to an increase of 22 basis points in our cost of interest-bearing deposits to 1.70% for Q1. Due to the current market pressure related to deposit rates, we expect to continue to experience an increase in the cost of our core deposits. This is illustrated by the cost of interest-bearing deposits being 1.78% for the month of March, with a spot rate of 1.80% as of March 31. Investment balances decreased $143 million during Q1, mostly due to the loss trade previously discussed. The security trades occurred in March; therefore, the benefits of the loss trade were not fully realized in Q1. Even without full realization of the loss trade benefit, the yield on the securities portfolio increased 15 basis points from the prior quarter to 3.30% for Q1. Moving on to the income statement, net interest income decreased $2.3 million from the prior quarter due to a decrease in both the net interest margin and average earning assets. The net interest margin decreased to 3.32% for Q1 from 3.41% in the prior quarter. This decrease was primarily due to the cost of interest-bearing deposits increasing more rapidly than yields on earning assets. Although the impact of the loss trade will partially mitigate other factors, the pace and duration of our decrease in margin will be highly dependent on continued increases in our cost of interest-bearing deposits as well as maintaining deposit balances. As our cost of deposits as well as the deposit balances level off, we expect to experience margin stabilization due to the repricing of adjustable-rate loans in addition to higher origination rates on new loans. We recognized a provision for credit losses in the amount of $1.4 million during Q1, which is similar to the provision expense in Q4. The provision expense was due substantially to loan growth experienced during the quarter. Noninterest expense decreased from the prior quarter due to lower FTE levels and lower costs related to contract renegotiations, partially offset by higher severance costs. Average FTE was 765 in Q1 compared to 803 in Q4, a reduction of 38 FTE. As was communicated in the last earnings call, we expect the expense run rate to be between $40 million and $41 million for the remainder of the year. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio remained at 8.8%. Our strong capital ratios have allowed us to be active in loss trades, on investments, and in stock buybacks. During Q1, we repurchased approximately 330,000 shares at a weighted average cost of $18.56 or 107% of March 31 tangible book value per share. As we announced in the earnings release, the Board has approved a new share repurchase plan in the amount of 5% of outstanding stock, which equates to 1.7 million shares. As we have done in the past, we will use the share repurchase plan to manage our capital levels.

Tony Chalfant, Chief Credit Officer

Thank you, Don. I'm pleased to report that credit quality at quarter end remained strong and stable. As of quarter end, nonaccrual loans totaled just under $4.8 million, and we do not hold any Other Real Estate Owned (OREO). This represents 0.11% of total loans and compares to 0.10% at the end of 2023. Nonaccrual loans increased by $324,000 during the quarter. Increases of just under $600,000 in the quarter came primarily from moving one Commercial and Industrial (C&I) loan to nonaccrual status. Partially offsetting this increase was $269,000 in loans that were either upgraded to accruing status or were paid off during the quarter. Page 18 of the investor presentation reflects the consistently low level of nonaccrual loans we've experienced over the past 2 years. Loans that are delinquent more than 30 days and still accruing stood at 0.21% of total loans at year-end, up from 0.11% at year-end 2023. Most of the increase is attributed to one classified relationship that is being actively managed by our special assets team. The loans remain on accrual status, as they are well secured and in the process of collection. Criticized loans totaled just over $172 million at the end of the quarter. This is an increase of $22 million over year-end 2023, almost entirely in the special mention category. The largest driver of this increase was the downgrade of one multifamily commercial real estate loan that represented just over $15 million of the total. Overall, criticized loans have trended modestly higher over the last 12 months. However, they remain in line with our historical performance with good economic conditions. Criticized loans at quarter end were 3.9% of total loans compared to 3.5% at year-end '23 and 3.3% at the end of 2022. The credit quality of our office loan portfolio remained stable in the quarter. This loan segment currently represents $551 million or 12.4% of total loans and is split evenly between owner and non-owner occupied properties. The loans continue to be granular in size and diversified by geographic location, with little exposure in the core downtown markets. Criticized office loans are limited to just over $18 million, which is down modestly from the $19.2 million reported at the end of 2023. We recently completed the targeted review of all significant office loans that have either a maturity or a repricing event over the next 2 years. The review focused on the adequacy of debt service coverage using current operating income and note rates, along with an estimated loan-to-value ratio using current cap rates. The review included 41 loans with $93 million in total outstanding balances. I'm pleased to report that we did not downgrade any loans to special mention or worse during this review. Page 17 of the investor presentation provides more detailed information about our office loan portfolio. During the quarter, we experienced total charge-offs of $200,000. The losses were offset by $233,000 in recoveries, leading to a net recovery position of $33,000 at quarter end. We continue to experience lower loan losses than historical norms. While we saw some modest deterioration in the first quarter, the credit quality of our loan portfolio remains strong. As we have discussed in prior quarters, we continue to see a slow move back to a more normalized credit environment, following a period of exceptionally high credit quality. We remain consistent in our disciplined approach to credit underwriting, and we believe this is reflected in the solid level of credit performance we have maintained over a wide range of business cycles.

Bryan McDonald, President and COO

Thanks, Tony. I'm going to provide detail on our first quarter loan production results, starting with our commercial lending group. For the quarter, our commercial teams closed $133 million in new loan commitments, down from $187 million last quarter and down from $228 million closed in the first quarter of 2023. Please refer to Page 13 in the investor presentation for additional detail on new originated loans over the past 5 quarters. The commercial loan pipeline ended the first quarter at $409 million, up from $329 million last quarter and down from $587 million at the end of the first quarter of 2023. Loan demand showed improvement in the first quarter, and new opportunities have continued to present themselves at the same level during April. Competition remains very high for quality commercial business, but we anticipate the pipeline will continue its upward trajectory in the second quarter. Loan growth for the first quarter was $92.5 million, up from $69 million last quarter, due to higher loan balances relative to commitments on loans closed during the quarter, lower prepayments and payoffs, and higher net advances on construction loans. Please see Slides 14 and 16 of the investor presentation for further detail on the change in loans during the quarter. Based on a higher projected level of construction loan payoffs in the second quarter and our building loan pipeline, we anticipate our loan growth rate to be mid-single digits near term and move back up to the first quarter levels in the second half of 2024. The deposit pipeline ended the quarter at $191 million compared to $207 million last quarter, and estimated average balances on new deposit accounts opened during the quarter were $40 million compared to $55 million last quarter. Moving to interest rates, our average first-quarter interest rate for new commercial loans was 7.05%, which is 12 basis points higher than the 6.93% average for last quarter. In addition, the first-quarter rate for all new loans was 7.15%, up 11 basis points from the 7.04% last quarter. The market continues to be competitive, particularly for C&I relationships.

Jeffrey J. Deuel, CEO

Thank you, Bryan. As I mentioned earlier, we are pleased with our accomplishments for the first quarter of 2024. While we continue to experience the challenges of the rate environment on our deposit franchise, we are confident that the strength of the franchise will continue to benefit us over the long term. Our relatively low loan-to-deposit ratio positions us well to continue to support our existing customers as well as pursue new high-quality relationships. We will continue to benefit from our solid risk management practices and our strong capital position, and we will continue to focus on expense management, improving efficiencies within the organization. Overall, we believe we are well positioned to navigate the challenges ahead and to take advantage of any potential dislocation in our markets that may occur. That's the conclusion of our prepared comments. So Lydia, we are ready to open the call up to any questions callers may have for us.

Jeff Rulis, Analyst

A question on the margin. Don, do you have the March average margin?

Donald Hinson, CFO

Yes. The margin for March was 3.30%.

Jeff Rulis, Analyst

What are your thoughts on margin stabilization? Could you clarify the timing? I understand there are many factors at play, but I would like to know if this is expected for the remainder of the year or if you believe we are reaching a low point in the second quarter due to the positioning you have undertaken.

Donald Hinson, CFO

I initially believed we would stabilize by midyear, but the rates have shifted. The expectations of rate cuts are affecting deposit pricing, which is rising more than I had anticipated. It seems likely that the stabilization is postponed to later in the year, as we approach the bottom of the margin. Fortunately, we have some advantages from our investment portfolio and new loan rates. However, the need to refinance the BTFP at higher rates will likely delay this further into the year.

Jeff Rulis, Analyst

Any thoughts on further repositioning or restructure that you've done in the last couple of quarters?

Donald Hinson, CFO

We don't have any plans right now to do any more. Obviously, it's always in the cards that we feel we have opportunities to take advantage of. Again, we have a strong capital position. But at this point, we do not use our capital for other purposes.

Jeff Rulis, Analyst

I wanted to address the loan growth aspect. The commentary is quite positive, and I’m curious about customer sentiment. It seems that the possibility of rates decreasing may have held some people back, but given that rates are expected to remain high for an extended period, there may be a need for businesses to proceed with their projects. Are you sensing that businesses are beginning to move forward in this new environment? Is that accurate? What are you observing?

Jeffrey J. Deuel, CEO

I believe that's accurate. We're seeing that customers who may have been waiting are now taking action and making progress. The current environment is quite favorable, with strong employment levels. Some customers have delayed their decisions for a long time but are finally moving ahead. It's important to note that the increase in loan production includes construction loans that were waiting to be funded, and overall, we are satisfied with that production level. Delving deeper into the numbers, there is a noticeable emphasis on growth in the commercial and industrial sector, which reflects the efforts of Bryan and his team to realign the production focus of the bank. We are pleased to see positive results from these efforts. As previously mentioned, we are prioritizing growth in loans and deposits, and currently, deposits are particularly valuable. This area requires a long-term strategy, and our team must remain dedicated to consistently attracting those deposits. Additionally, we are benefiting from market disruptions stemming from various events from last year, and I expect this trend to continue for the remainder of the year.

Jeff Rulis, Analyst

Okay. And Don, the tax rate, is it a kind of a range bound in that 15% to 17% range? Is that fair?

Donald Hinson, CFO

We had some discrete items occur in Q1 related to the vesting of stock awards. I think going forward, we're probably looking more in the 14% range for the remainder of the year.

Matthew Clark, Analyst

Maybe, Don, just first on the timing of the loss trade. Was that late in the quarter? Just trying to get a sense for whether or not that 3.30% NIM in March reflected that benefit fully or not?

Donald Hinson, CFO

Matthew, it did not, it occurred all in March. So it occurred during March. Obviously, Q1, it did not impact it nearly as much as...

Matthew Clark, Analyst

Okay. And then the size of the BTFP that you have out there, it sounded like you might refinance it, but I also thought you had proceeds here you can use to pay it off. I just can't remember the size.

Donald Hinson, CFO

It's $400 million maturing in early May. We didn't reinvest about $100 million from the loss trades, so we have that available for cash needs moving forward to potentially reduce that balance. We can't use the BTFP any further since it ended in March, but we will utilize other methods for borrowing when that matures.

Matthew Clark, Analyst

Okay. And then just on deposits, what does the pipeline look like there relative to last quarter? And then what are your latest thoughts on when and where noninterest-bearing might be able to stabilize?

Jeffrey J. Deuel, CEO

Bryan, do you want to talk about the deposit pipeline?

Bryan McDonald, President and COO

Yes, the deposit pipeline ended the quarter at $191 million, which is a decrease from $207 million at the end of the previous year. The new business we closed during the quarter is estimated to have brought in about $40 million. Regarding the noninterest-bearing migration, it's challenging to predict. We're noticing that customers are being more cautious with their operating accounts, maintaining lower balances compared to when interest rates were lower. Don, I'll let you take over from here.

Donald Hinson, CFO

I don't have much to add on that. Clearly, we see that continuing to decline. It's challenging to predict when it will reach its lowest point. We're already below the levels we had at the end of 2019, and there was likely a significant amount of excess funds at that time. We're currently under 30%. I would expect us to start leveling off and likely remain in the high 20% range, but that's just an estimate for now. It's difficult to determine exactly where we will end up.

Jeffrey J. Deuel, CEO

And Matt, it's still pretty focused on the access funds that customers have in their operating accounts. The traditional operating account balances remain quite consistent. In response to Jeff's earlier question regarding the type of activity we're observing, we're mainly seeing basic activity with our customers, with funds transferring in and out of accounts. They're purchasing buildings, making investments, and engaging in various activities. So, the flows are quite traditional at this time.

Matthew Clark, Analyst

Okay. And then can you quantify how much you had in brokered CDs this quarter versus last?

Donald Hinson, CFO

We had $115 million at the end of the quarter. And I believe it's about the same as we had last quarter.

Matthew Clark, Analyst

Okay. Okay. And then just the step up in special mention, what drove that increase by kind of customer type and kind of the situation there?

Tony Chalfant, Chief Credit Officer

Yes, Matthew, this is Tony. We primarily had one commercial real estate loan, which is a construction loan, but the property is completed and we're just facing some lease-up issues. We decided it was necessary to move that to special mention. Additionally, there was one smaller commercial and industrial loan involved as well. Between those two, they made up the majority of the moves. Substandards remained stable from quarter to quarter; the changes were mainly in the special mention category.

Matthew Clark, Analyst

Okay. And then last one for me, just around kind of capital return. Is it fair to assume M&A is unlikely just given your currency, the marks, the approval process being extended? And should we just all then assume that you're going to be more active with the buyback than you were this quarter throughout the year?

Jeffrey J. Deuel, CEO

On the first part, Matt, M&A for us and generally in the region with the banks of the site that we'd be interested in is just pretty quiet. I think it's hard for them to face into where our currency is now and it's complicated, as you pointed out, for all those reasons. Buybacks, I think I'll leave that for Don to respond to.

Donald Hinson, CFO

We expect to be somewhat active with buybacks depending on the stock price and our capital needs, likely similar to what we did in Q1. However, we don't plan to complete the repurchase plan in just one or two quarters. We believe our stock price is currently very attractive for buybacks, so we will probably remain active.

David Feaster, Analyst

I'm glad to hear the pipeline has improved. We touched on loan growth a bit, but I'm curious about how the complexion of the pipeline is shaping up. How is pricing there? What do you think is driving it? Is it improving demand or an increased appetite for credit from your perspective? More broadly, what's the pulse of your clients?

Jeffrey J. Deuel, CEO

Bryan, that's probably a good one for you to respond to.

Bryan McDonald, President and COO

Yes, happy to, Jeff. So David, the big shift in the pipeline has happened over the last year. This time last year, we had a larger component of the pipeline that was investor real estate. And then when the liquidity crisis hit, we saw those requests just really increase. We made a shift with our sales team and said, we really want to migrate the portfolio primarily to commercial business. And so what we've seen over the last 12 months is closing those deals that we had in the pipeline that actually continued through to closing, but the sales teams for a year now have been primarily focused on C&I. It's something the banks obviously focused on for a long time. We just had a higher segment of the pipeline last year at this time that was an investor. So when you look at the pipeline today, it's close to 70% in C&I and owner-occupied real estate, and that's kind of across the footprint. And that's really the changes. And we've seen this building through the first quarter and even into April, the number of new opportunities in that commercial space have just continued to add on versus the last 12 months where we've been deducting out the CRE loans that we weren't going to continue through to closing for a variety of reasons. So it's that transition in the pipeline in terms of the mix. And then yes, we're seeing broad-based demand a bit higher than what we had in the fourth quarter. Net-net, it's really the result of our sales force making more dedicated calling efforts and some improvement in the demand side from the customer here in 2024.

David Feaster, Analyst

Okay. Terrific. That's helpful. And then maybe, I'm curious your thoughts on credit more broadly. You've got a reputation as a conservative credit manager, quick to downgrade, slowed upgrades. So I'm just kind of curious, what you're seeing, maybe what you're watching more closely? And how you're thinking about managing credit? And just, you alluded to a more competitive landscape, curious maybe if you could elaborate that on what you're seeing from the competition standpoint as well.

Jeffrey J. Deuel, CEO

Well, that's probably a good question for you, Tony, but I'd kick it off by saying, Tony did mention, David, that we continue to underwrite loans as we always have done. So conditions changing doesn't necessarily mean we change the way we approach credit. So Tony, maybe you want to add to that with what you're seeing out there?

Tony Chalfant, Chief Credit Officer

Yes, David, I would like to add to that. As I mentioned in the last few calls, we are observing a return to more normal conditions compared to the credit bubble experienced over the last few years. Typically, we consider 9 or 10 basis points in the portfolio as a solid year for net charge-offs, and we have just come off two consecutive years of net recoveries. Broadly, I'm noticing some operating companies facing more challenges than they have in the past few years. Occasionally, commercial real estate projects are not achieving the expected net operating income and rental rates. There are some instances where transitioning from construction to permanent financing is becoming more difficult as projects reach the stabilization phase. However, these appear to be isolated incidents, and nothing stands out as being widespread or systemic at this time.

David Feaster, Analyst

Okay. Perfect. And then the last one for me, we briefly touched on this with Matt's question, but I wanted to understand how you plan to manage the balance sheet moving forward. It seems there are no plans for further restructuring. We have made progress with the BTFP pay down, but I'm interested in what other options you might be considering and how those plans might shift in a higher-for-longer environment.

Donald Hinson, CFO

Well, for a for higher for longer, I think that we're looking at, again, or even things like the high-cost funding that we might have expected to come down, and maybe it's not going to at this point. So it is a challenge to manage the balance sheet in the current environment when you actually don't know which way the rates are going. Right? Obviously, everybody thinks they are coming down, but there's always a chance that could go up. So that's why in the last loss trade, we held on to some cash, going to pay down some debt. We'll be looking to probably pay down debt, which means that our overall asset levels will probably not increase over the near term. But we're looking to hopefully improve profitability. Again, it might allow for stock buybacks without actually impacting capital if we reduce assets. And so I guess those are the type of things where we'll take advantage of what's in front of us, such as potential buybacks at this point and other restructuring of the balance sheet that we feel makes sense for both short term and long term in various rate environments. And of course, balance sheet management is both looking at your kind of sustainable profitability and risk. So we'll be balancing those two things as we look forward.

David Feaster, Analyst

Your prediction is as uncertain as mine. A lot of this is just a matter of time and adjusting our pricing strategy. When do you think we will return to normal levels of profitability?

Donald Hinson, CFO

If the yield curve stays inverted, it will likely take a while to return to historical profitability levels, as commercial banks are not typically very profitable in such conditions. However, if we can achieve at least a flat yield curve, it will be challenging to reach those profitability levels again.

Andrew Terrell, Analyst

Most of mine were addressed already. I just had one quick follow-up on some of the securities restructuring. Just Don, do you have the spot yield on the securities book as of 3/31?

Donald Hinson, CFO

Andrew, I do not have that. I'm sorry. I think it's not much different than probably a little higher than it was for the quarter. But if I can find that quickly, I'll look that up, but I don't have that on me.

Operator, Operator

We have a question from Timothy Coffey of Janney Montgomery Scott.

Timothy Coffey, Analyst

Don, just a couple of check-the-box questions for you. The balance sheet restructuring benefits, that is embedded in kind of your NIM outlook. Is that correct?

Donald Hinson, CFO

That is correct, Tim.

Timothy Coffey, Analyst

Okay. And then you also said repurchases in the quarter were 130,000 shares?

Donald Hinson, CFO

It's 330,000. I think it was.

Timothy Coffey, Analyst

Yes, okay, great. And then, Tony, I have a question for you. I appreciate the discussion regarding the special mention loan, particularly the one that increased special mentions and where some of the stress lies. I'm curious if you have an idea of how many of those types of commercial real estate loans in your portfolio involve a rehabilitation phase, especially those that have encountered challenges or are currently facing difficulties during the leasing phase.

Tony Chalfant, Chief Credit Officer

Yes, Tim, just off the top of my head. I think that's really the only one I can think of that we've had a significant issue. I mean we have had situations where we've put something on a watch status because we recognized that there were some issues, but those have tended to resolve themselves. We had one a while ago that was in that position. The borrowers chose to sell the property actually at a nice profit rather than reinject more equity into the deal. So we try to catch them early and recognize that, and more often than not, because so many of our deals have guarantors behind, individual guarantors with some financial strength, we're able to sort of right-size it or fix it before it becomes an issue.

Timothy Coffey, Analyst

Okay. The breakout that you gave on the criticized loans, which I really appreciate, and I fully understand they are criticized loans. The construction and developments team is about 18% of that. What type of construction loans would they be?

Tony Chalfant, Chief Credit Officer

I think they are going to be primarily a lot of the construction loans, but I'm not completely sure about that. Yes, yes. Okay. We can follow up on that offline.

Jeffrey J. Deuel, CEO

Thank you, Lydia. Happy to wrap up the quarter's earnings calls. We thank you for your time and support and interest in our ongoing performance, and we look forward to talking with many of you in the weeks ahead. Thank you, and goodbye.

Operator, Operator

Thank you again for joining. A replay of today's call will be available shortly. To access the replay, please dial +1 (404) 975-4839 and enter the access code 070217. Thank you.