Earnings Call Transcript - HFWA Q1 2022

Operator, Operator

Good afternoon. Thank you for attending today's Heritage Financial Corporation Q1 2022 Earnings Conference Call. My name is Hannah and I will be your moderator for today's call. I would now like to pass the conference over to our host, Jeff Deuel, the CEO of Heritage Financial Corporation. Please go ahead.

Jeff Deuel, CEO

Thank you, Hannah. Welcome and good morning to everyone who called in and those who may listen later. This is Jeff Deuel, CEO of Heritage. Attending with me are Don Hinson, Chief Financial Officer; Bryan McDonald, President and Chief Operating Officer; and Tony Chalfant, Chief Credit Officer. Our earnings release went out this morning pre-market and hopefully you would 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 website, which can be found at heritagebanknw.com. We will reference the presentation during the call. Please refer to the forward-looking statements in the press release. We're happy to report on the positive progress we have made this quarter. Annualized loan growth excluding PPP was a respectable 9.5% for the quarter. This growth was aided by lower payoffs, higher line utilization, and a pool of purchased residential mortgage loans. We are pleased with the positive trend we see in the number of new commitments and new loan closings. Even with our conservative credit box, we're getting our fair share of the new deals. We continue to see deposit growth with minimal runoff resulting from our branch consolidations in 2021. Our pipeline of loans and deposits is strong and we expect it to continue to grow through the balance of the year. We maintain our focus on carefully managing expenses with good success, as evidenced in the non-interest expense number, which was down 7% from Q4 levels. Notably, our long-standing focus on credit quality and actively managing our loan portfolio continues to play out well for us as the pandemic recedes. Staying focused on our risk profile has enabled us to continue to report improving credit trends. We also continue to benefit from the recapture of a portion of the reserve build from 2020. ACL is now settling in at 1.07% excluding PPP compared to the pre-pandemic ACL of 1.01%. In spite of lingering COVID concerns, it is exciting to be facing a more normalized and positive business environment for organic growth resulting from the economic vitality of the Pacific Northwest. We'll now move to Don who will take a few minutes to cover our financial results.

Don Hinson, CFO

Thank you, Jeff. As Jeff mentioned, overall financial performance is very positive in Q1, and I'll be reviewing some of the main drivers of our performance. As I walk through our financial results, unless otherwise noted, all the prior period comparisons will be with the fourth quarter of 2021. Starting with net interest income, there was a decrease of almost $1 million, due mostly to a $1.8 million decrease in income from PPP loans. The balance of PPP loans was down to $65 million at quarter end, and its impact on net interest income will lessen as we progress through the year. Partially offsetting this was an increase in income from investment securities. This was due mostly to an increase in average investment balances of $248 million, or 21% from the prior quarter. We expect to continue to be active in investment purchases due to our large overnight cash position. Further information on the investment portfolio is shown on Page 28 of the investor presentation. The net interest margin was relatively stable from the prior quarter, down only 1 basis point. Helping the margin in Q1 was the impact of interest recoveries on non-accrual loans which impacted loan yields by 11 basis points in Q1 compared to just 1 basis point in the prior quarter. Offsetting these positive impacts to margin was the previously mentioned decline and impact from PPP loans and lower overall yields in the investment portfolio, which was due partly to purchasing lower duration securities and partly due to additional interest recognized in Q4 as a result of pre-payments on securities. However, even with lower yields, investments help improve the margin in Q1, due to the deleveraging of our cash position. We had another good quarter for deposit growth. Total deposits grew $97 million or 1.5% in Q1, and have grown $458 million or 7.6% year-over-year. Cost of total deposits were 9 basis points for Q1, the same level as the previous two quarters, as shown on Page 27 of the investor presentation. All of our regulatory capital ratios remain strongly above well-capitalized thresholds. And we continue to have a very strong liquidity position. We did experience a decline in our TC ratio to 7.9% due to the impact of market rates on the fair value of the available for sale portion of the investment portfolio. Overall, our TCE ratio was lower than historical levels due to significant balance sheet growth, mostly in the form of cash that we have experienced over the last couple of years. You can refer to Page 32 of the investment presentation for more specifics on capital and liquidity. Non-interest income decreased $1.3 million from the prior quarter due primarily to the $2.7 million gain on sale of property we recognized in Q4, partially offset by an increase in income due to the Q1 recognition of a death benefit. We continue to see nice improvement in our overhead ratio due to the combination of expense management measures and asset growth. Our overhead ratio decreased to 1.95% compared to 2.06% in the prior quarter. Although we have benefited from our expense management measures, we do expect our expenses to increase over the next few quarters due to inflationary pressures on compensation expense and continued technology investments. As occurred throughout 2021, a significant impact to our earnings for Q1 was a reversal of provision for credit losses in the amount of $3.6 million. Factors for the provision reversal included a decrease in the impact from non-accrual loans, an improved economic outlook, changes in the loan mix, and improvement in overall credit quality metrics. I will now pass the call to Tony who will have an update on these credit quality metrics.

Tony Chalfant, Chief Credit Officer

Thank you, Don. I'm happy to share that our credit quality remains robust, with continued improvement across our portfolio. In the first quarter, non-accrual loans fell by $7.2 million, a reduction of 30% from the end of 2021, and we have no real estate owned reported from previous quarters. Currently, non-accrual loans are down 72% compared to December 31, 2020, the peak of this credit cycle. As of March 31, non-accrual loans amounted to $16.5 million, constituting 0.43% of total loans and 0.22% of total assets. The notable improvement this quarter was mainly due to pay downs and payoffs on troubled loans, resulting from effective long-term workout strategies. From these transactions, we recovered just over $1 million in interest and fees. Additionally, we upgraded three borrowing relationships back to accrual status, as these borrowers, previously impacted by COVID, improved their financial performance sufficiently for an upgrade. Recently, we haven't seen any major new additions to our non-accrual loans, maintaining that trend, we did not move any loans to non-accrual status during the quarter. Our success in diminishing non-performing assets is outlined in Page 24 of the Investor Presentation. Criticized loans, categorized as Special mention and substandard, decreased by about 5% or $9 million in the first quarter. At just under $175 million, we're progressing towards a normal level for a healthy economy. However, criticized loans remain $32 million higher than December 31, 2019, which we view as our pre-pandemic level, largely due to our hotel portfolio. This portfolio has around $63 million in criticized loans. Though these properties are showing improved cash flow, their performance hasn’t yet reached a level that allows for a return to a pass rating. With the travel industry rebounding in 2022, we anticipate being able to upgrade many of these loans in the latter half of the year. More information regarding the COVID-impacted industries we are monitoring can be found on Page 23 of the Investor Presentation. In the first quarter, we faced charge-offs of $355,000, split between commercial and consumer loans, but this was more than compensated by recoveries of $849,000, leading to a net recovery of $494,000 for the quarter. We also sold a small pool of 14 problem loans totaling $855,000 to a third-party investor. Although this sale included a minor net charge-off of $41,000, we were able to record a $163,000 recovery of interest income. Like many regions, ours continues to face challenges due to supply chain and labor shortages, in addition to ongoing high inflation. Nevertheless, both Washington and Oregon's economies are performing strongly and have rebounded significantly following the lifting of COVID-related restrictions. We are witnessing increased competitive pressure on our loan structures as banks seek to utilize their excess liquidity. Heritage Bank has not relaxed our underwriting standards, as we remain dedicated to maintaining a moderate risk profile through all business cycles. I will now hand the call over to Bryan for an update on loan production.

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 $225 million in new loan commitments, down from $329 million last quarter and roughly even with the first quarter of 2021. Please refer to Page 18 in the Q1 investor presentation for additional detail on newly originated loans over the past five quarters. The commercial loan pipeline ended the first quarter at $527 million, up from $462 million last quarter, and down from $540 million at the end of the first quarter of 2021. We have been seeing an increase in new loan requests from customers and prospects since July of 2021 when the governors of Washington and Oregon lifted many of the pandemic restrictions. We saw this trend accelerate during the first quarter of 2022. Organic loan growth during the quarter was augmented by the purchase of a residential mortgage pool and negatively impacted by the runoff of both the SBA PPP balances and the indirect loan portfolio, a business line we discontinued in 2020. Loans increased $61 million during the quarter, or a 6.9% annualized rate, excluding the impact of SBA PPP, indirect loan balance declines and the Residential Mortgage purchase. Although new loan production was down for Q4 from Q4 2021, we benefited from higher utilization rates and lower prepayment and payoffs as detailed on Slides 19 and 20 of the investor deck. Consumer loan production, the majority of which are home equity lines of credit was $22 million during the quarter, which is down from $23 million last quarter and up from $16 million in the first quarter of 2021. Moving to interest rates, our average first quarter interest rate for new commercial loans was 3.54%, which is 17 basis points lower than the 3.71% average for last quarter. In addition, the average first quarter rate for all new loans was 3.39%, down 11 basis points from 3.48% last quarter. Of the 11 basis point decline, eight can be attributed to the mortgage pool purchase. Although the marketplace continues to be very competitive, we are seeing the recent rate increases translate into higher quoted rates on new loans. With this, we anticipate Q1 to be the bottom of the current cycle, with our reported loan rates expected to increase from here. The mortgage department closed $37 million of new loans in the first quarter of 2022, compared to $45 million closed in the fourth quarter of 2021 and $43 million in the first quarter of 2021. The mortgage pipeline ended the quarter at $27 million versus $29 million in Q4 and $36 million in the first quarter of 2021. Refinances made up 77% of the pipeline at quarter end. With interest rates rising, we anticipate refinance volumes will decrease and overall mortgage volume will trend down in 2022. I'll now turn the call back to Jeff.

Jeff Deuel, CEO

Thank you, Bryan. As I mentioned earlier, we're very pleased with our performance in the first quarter. We're seeing a nice upswing in organic production across the bank, with deals coming from existing customers and new high-quality prospects. We are prepared for high single-digit loan growth and we are optimistic that this level of loan production is achievable for us as the year progresses. We also still believe there will be opportunities to add talent to the team and new customers to the book as a result of dislocation in our markets. We rationalized our expense base last year, and we will continue to focus on expense control in '22. Although we do expect to experience inflationary pressures like everyone else. We have also continued to focus on our technology strategy, which is designed to support more efficient operations, a more consistent customer experience, and positions us well to pivot as bank technology continues to evolve, and we continue to grow. As a reminder on Page 7 of the investor deck, we have included a graphic overview of our technology strategy, and you will see that several segments of the Heritage One platform are in production. We will continue to refine these segments, and we'll be adding additional capabilities in the future. We are also prepared to pursue acquisitions in the three-state region when we see the right opportunities for us. As Don mentioned earlier, our capital levels and our robust liquidity provide us with a strong foundation to address challenges and take advantage of opportunities. That concludes our prepared comments. So, Hannah, we're ready to open up the line to questions that anybody may have.

Operator, Operator

The first question is from the line of Jeff Rulis with D.A. Davidson. Please proceed.

Unidentified Analyst, Analyst

Hi. This is Andrew on for Jeff Rulis. I saw in the Investor Deck, there is net interest margin excluding accretion, but I was wondering if there's a figure for net interest margin excluding PPP, interest recoveries, and accretion. Thanks.

Jeff Deuel, CEO

Good morning, Andrew. Thanks for the question. Don, I'll pass that one to you.

Don Hinson, CFO

Sure. If we strip out, you might say everything that happened this last quarter on all those areas, it would probably be about 260 would be the margin, which is really unchanged in the prior quarter. If you strip out all those things.

Unidentified Analyst, Analyst

Perfect. Thank you. And maybe just one other question on buyback appetite. How does that compare to last quarter?

Jeff Deuel, CEO

Well, we're not looking to do a lot of buybacks like similar to last quarter. We did about 80,000 to kind of keep the share count about the same. So, we don't have a big appetite for buybacks with a TCE ratio again around 7.9. So, we'll probably be holding pretty steady on that.

Unidentified Analyst, Analyst

Sounds good. Thanks so much. I'll step away.

Operator, Operator

Thank you. Our next question is from the line of Kelly Motta with KBW. Please proceed.

Kelly Motta, Analyst

Hi. Good morning. Thanks for the question. I appreciate all the color around expenses and the work you did last year to lower that and it came in lower than I expected for the quarter. I think your guidance last time around was about $37 million to $38 million a quarter. You said you expect expenses to go up from here is that $37 million to $38 million still kind of a good outlook for the rest of the year given the increases you see.

Jeff Deuel, CEO

Yes. Good morning, Kelly. Yes, that is appropriate for us. I think that the reason why it's a little bit lower is a variety of factors. One of which is we've been working on it for a while, so we're getting some of the benefits of our efforts. But we've had some folks on our team transition to retirement, and we haven't necessarily replaced all of them yet. And I think to that, like everybody else, we're experiencing the great relocation or reorientation, whatever you want to call it in terms of people choosing to do other things and move around. So, I think it's a combination of things. But when you consider that we'll be refilling many of those seats, and the inflationary impact on wages that we feel is coming at us this year, I think it's safe to say that we will be in that range as the year progresses. Don, anything you'd like to add?

Don Hinson, CFO

Yes, just I think that we will be back up in that range towards the last half of this year. This next quarter will probably be somewhat transitional on that we may not get there this next quarter, but I think the last half of the year.

Kelly Motta, Analyst

Thanks. That's helpful. And then looking at your loan growth, it was really strong this quarter and I appreciate the outlook, I think you said for high single-digit growth. I see you purchased some residential mortgages during the quarter. I was wondering if that was more of a one-time thing, or if there's appetite to purchase maybe similar amounts going forward and how that factors into your loan growth outlook?

Jeff Deuel, CEO

Yes, we have not done that before and it was a good experience for us. It's just another lever that we have to manage the excess cash we have on our balance sheet. I think it's notable to point out that those mortgages we did buy fit very well with our credit box and our risk profile from the standpoint of geographies and the way they were underwritten. So, it's not like we've ventured forth and done something really extremely different. I think we probably will continue to potentially utilize that as a lever going forward to help us leverage up the balance sheet. Don, any thoughts that you have on that you want to add?

Don Hinson, CFO

No, I think it will depend on where we're at and even what spreads we're getting compared to investments. But I think it went well. Again, as Jeff mentioned, we basically used the same underwriting criteria we would if we originated the loans and also in their same geography. So, it's not like we're going out away from our risk profile to do these.

Jeff Deuel, CEO

So, we'll very likely we will do more; how much will depend on this environment.

Kelly Motta, Analyst

Great. And then last question for me tying into liquidity and also just the strong deposit growth you have given how much liquidity you have, and it's nice to see it getting put to work into loans. Can you help us a bit with the deposit side of the balance sheet expectations for the deposit paid up for the first 100 basis points of rate hikes and then thereafter I would assume given how much liquidity you have you can kind of temper the impact to funding costs, but just interested in any commentary there. Thank you.

Jeff Deuel, CEO

Don, you want to take that?

Don Hinson, CFO

Sure. You know I think with the liquidity in the system, we have betas in our when we do our industry risk analysis and the betas are probably averaged around 30%. But there's always a lag period when it comes to deposit rate increases and I think in this current environment with all the liquidity that's on the balance sheet of banks, that lag period could go further; we get the numerous rate increases forecasted. I'd see later in the year that we may need to start raising rates. There's been no current pressure, maybe one-off exceptions, but we get the last half of the year. We could see some pressure there, but I'm not expecting a lot even when we were in the last cycle when the rates were higher. Our total cost deposits were still pretty low. I don't think it's going to be a big impact.

Kelly Motta, Analyst

That's really helpful. Thanks. I will step back now. I appreciate all the color.

Jeff Deuel, CEO

Thanks, Kelly.

Operator, Operator

Thank you. The next question is from the line of Matthew Clark with Piper Sandler. Please proceed.

Matthew Clark, Analyst

Hey, good morning, guys. I wanted to touch on the near-term margin outlook. I think in the prior quarter, you thought Q1 would be the bottom. I know you guys did some SFR purchases, the weighted average rate on new loans was down a little bit. But you've got — you have a Fed rate increase here in March and another one, a bigger one in May. Can you just give us your thoughts on kind of near-term margin outlook and the trajectory of loan yields from here?

Jeff Deuel, CEO

Don, you want to take that?

Don Hinson, CFO

Yes, I will take that too. I think we're really pretty positive about where we're going with them going in the next few quarters. I just start looking at our overall balance sheet with the amount of cash that we have, and say that we get 250 basis point increases, which certainly looks likely this next quarter. We could see even overnight cash, the yields on that go up, around 60 basis points. So, and then, our if you strip out some of the recoveries, the core loan yields, I think that we're going to see that. I like going to page — Matthew, if you can go to Page 30 of our investor presentation, that really helps to me tell the story of a lot of what's going to happen to our balance sheet, where we've got 22% over at cash, and we've got a decent amount of our loans that are floating and even some investments about 10% of our investment portfolio. So, I'm pretty optimistic about where the margin is going. Some of it will be dependent on the spreads that we get on new loans, but I think we have hit bottom, and we'll start increasing every quarter this year.

Matthew Clark, Analyst

Great. Okay. Thank you. And then just on the reserve coverage ratio, down a little bit further here. I think your day one level was 101. I think we had previously thought you might get below that. And given the growing uncertainty in the macro environment. I mean, do you feel like you can dip below day one still, at some point here? Or do you feel like you need to kind of maybe stabilize there?

Jeff Deuel, CEO

Well, Don, you might. Go ahead, Don.

Don Hinson, CFO

No, all right. Well, I think that we're one-on-one on day one. We're 107. We've had an acute period of no losses at the same time. We are factoring in the inflationary pressures, the potential for a recession in the next year or two. There's certainly some pressure on certain aspects of our portfolio. We are not feeling it now. But we certainly are aware of things like, again, continuing to monitor things in hotels, restaurants, even office space. What's the need going to be for that? So, we're monitoring all those things. We're factoring those in our allowance. I can't predict what's exactly going to happen. But if we don't end up with losses, we're certainly probably be down to where we were. And there's always a possibility we could be below that.

Matthew Clark, Analyst

Got it. Okay. And then just on the M&A topic, I know you touched on it, just in your prepared comments. But can you give us a sense for kind of the change in the level of discussions relative to last quarter and whether or not there's anything? Not imminent, but just that's getting any closer to getting done here? Maybe by the end of the year?

Jeff Deuel, CEO

I don't think the environment for M&A has changed much for us, Matt. As we've said, for many, many quarters, we've spent a lot of time keeping tabs and keeping in touch with our targets we're most interested in and I think we have a rapport with all of them that if something's going to happen, we'll hear about it. But no, I don't see that things have changed that would cause us to expect anything in the near term.

Matthew Clark, Analyst

Okay. And then your other comment around digitalization opportunities that you expect to emerge? Any increased level of conversations with bankers, of other banks, in the midst of M&A, or are there still kind of on the come?

Jeff Deuel, CEO

Yes, we made the same comment last quarter. I think we expected that it would take some time for those opportunities to present themselves and I think that’s still the case. I think we said in the last call probably later in the year. I think at this point everyone is still getting sorted out. So, I would say it's on the come.

Operator, Operator

Thank you, Mr. Clark. There are no additional questions waiting at this time. So, I will turn the call over to Jeff Deuel for closing remarks.

Jeff Deuel, CEO

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

Operator, Operator

Thank you, Mr. Deuel. As a reminder, there will be a replay available after the call. To access the replay, please call 1-866-813-9403 and key in the access code 921221. That concludes today's call. Thank you for your participation. You may now disconnect your lines.