Earnings Call Transcript - HFWA Q4 2025

Operator, Operator

Hello, everyone, and welcome to the Heritage Financial 2025 Q4 Earnings Call. My name is Emily, and I'll be coordinating your call today. I would now like to turn the call over to Bryan McDonald, President and CEO, 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 fourth quarter earnings release went out this morning premarket, and hopefully, you've had the opportunity to review it prior to the call. In addition to the earnings release, we also posted an updated fourth 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. Our improving net interest margin and a shift in our loan mix benefiting the provision expense drove earnings higher in the fourth quarter. On an adjusted basis, diluted earnings per share was up 18% versus last quarter and up 29% versus the fourth quarter of 2024. And on the same adjusted basis, our ROA improved to 1.29% versus 0.99% in the fourth quarter of 2024. We now have regulatory and shareholder approval for the pending merger with Olympic Bancorp and plan to close at the end of January. 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 will now move to Don, who will take a few minutes to cover our financial results.

Donald Hinson, CFO

Thank you, Bryan. I will be reviewing some of the main drivers of our performance for Q4 as I walk through our financial results, unless otherwise noted, all the prior period comparisons will be with the third quarter of 2025. Starting with the balance sheet. Total loan balances increased $14 million in Q4. Yields on the loan portfolio were 5.54%, which is 1 basis point higher than Q3. The positive impact of new loans being originated at higher rates and adjustable rate loans repricing higher was partially offset by the impact of three rate cuts over the last four months of the year. Bryan McDonald will have an update on loan production and yields in a few minutes. Total deposits increased to $63 million in Q4. This increase was due primarily to a $100 million increase in interest-bearing demand deposits. The cost of interest-bearing demand deposits decreased to 1.83% from 1.89% in the prior quarter. As a result of rate cuts in Q4, we expect to see continued decreases in the cost of deposits. Investment balances decreased $31 million due primarily to expected principal cash flows on the portfolio. The yield on the investment portfolio decreased 9 basis points to 3.26% for Q4 compared to 3.35% in Q3. This decrease was partially due to a bond called in Q3 that provided approximately 4 basis points of additional accretion income that quarter and partially due to the runoff of higher-yielding bonds without replacement of those balances at current market rates. The cash flows provided by the investment portfolio as well as growth in deposits was used to pay down borrowings during the quarter. Borrowing balances decreased to $20 million at year-end from $138 million at the end of Q3. The remaining balances all mature in 2026. Moving on to the income statement. Net interest income increased $1 million or 1.7% from the prior quarter due primarily to a higher net interest margin. The net interest margin increased to 3.72% from 3.64% in the prior quarter and from 3.36% in the fourth quarter of 2024. We recognized a reversal of provision for credit losses in the amount of $814,000 in Q4. This reversal was due primarily to a change in the mix of the loan portfolio. During Q4, commercial construction loans decreased while permanent commercial real estate loan balances increased. We consider construction loans to have an inherently higher credit risk component and provided a much higher allowance on those loans. Therefore, the reallocation of those balances resulted in the allowance decreased to 1.10% in Q4 from 1.13% in Q3. In addition, net charge-offs remain at very low levels. Tony will have additional information on credit quality metrics in a few moments. Noninterest expense decreased $132,000 from the prior quarter due mostly to lower merger-related expenses. Compensation and benefits expense was higher due primarily to increased incentive compensation accrual and not due to additional employees. We continue to manage our employee levels carefully as shown by decreases in average FTE from both the prior quarter and the same quarter in the prior year. And finally, moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds and our TCE ratio was 10.1%, up from 9.8% in the prior quarter. We were inactive in both lost trades on investment and stock buybacks in Q4. I will now pass the call over to Tony, who will have an update on our credit quality.

Tony Chalfant, Chief Credit Officer

Thank you, Don. I'm pleased to report that we ended the year with strong credit quality across all segments of our loan portfolio. Nonaccrual loans totaled $21 million at year-end, and we do not hold any OREO. This represents 0.44% of total loans and compares to 0.37% at the end of the third quarter. The increase was primarily attributed to three non-owner-occupied CRE loans that were moved to nonaccrual status due to their delinquency. These loans are all well secured and are expected to pay off from either sale or refinance of the underlying properties with no anticipated loss. Total nonaccrual additions of $4.4 million were partially offset by $1.1 million in payoffs or paydowns. Within our nonaccrual loan portfolio, we have just over $2.4 million in government guarantees. Nonperforming loans were stable during the quarter with the 0.44% of total loans matching the ratio at the end of the third quarter. In addition to nonaccrual loans, loans over 90 days and still accruing were limited to one small residential mortgage loan with a balance of $194,000. Criticized loans moved lower during the quarter. However, we did see an increase in our substandard loans. Criticized loans totaled just under $188 million at year-end, declining by $6.6 million during the quarter. While special mention loans were lower by 29%, some were downgraded to substandard, resulting in a 24% increase in that risk category during the quarter. The largest contributor to the increase came from the downgrade of two C&I relationships totaling just under $30 million. Partially offsetting the downgrades was the resolution of a long-term problem loan workout for a non-owner-occupied CRE loan, resulting in a full payoff of $15.6 million. While we are closely watching this increase in substandard loans, they remain at manageable levels at 2.44% of total loans 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 over the past two years. During the quarter, we experienced total charge-offs of $640,000, primarily in our commercial loan portfolio. The losses were partially offset by $159,000 in recoveries, leading to net charge-offs of $481,000 for the quarter. For the full year, total net charge-offs were just under $1.4 million or 0.03% of total loans. This compares favorably to our 2024 performance, where net charge-offs were just over $2.5 million, representing 0.06% of total loans. We are pleased that our early identification and proactive management of problem credit has led to another year of exceptionally low loan losses. The correlation between these credit management practices and our low level of historical loan losses is demonstrated on Page 20 in the investor presentation. Overall, we remain pleased with the credit quality of our loan portfolio at year-end. We believe our consistent and disciplined approach to credit underwriting and concentration management will continue to generate strong credit quality performance in a wide range of economic conditions. 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 fourth quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $254 million in new loan commitments, down from $317 million last quarter and down from $316 million closed in the fourth 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 fourth quarter at $468 million, down from $511 million last quarter and up modestly from $452 million at the end of the fourth quarter of 2024. As anticipated, loan balances were fairly flat quarter-over-quarter with a $14 million increase in the quarter. Total new loan production of $271 million was largely offset with elevated payoffs and prepaids. Looking year-over-year, prepayments and payoffs were $208 million higher than the prior year and net advances on loans have swung from a positive $153 million last year to a negative $81 million in 2025. Please see Slides 13 and 16 in the investor presentation for further detail on the change in loans during the quarter. Looking ahead to 2026, we expect to resume loan growth at more historical levels as we are through the period of elevated loan payoffs, and we expect net advances to move back to a positive position. Deposits increased $63 million during the quarter and were up $236 million for the year. The deposit pipeline ended the quarter at $108 million compared to $149 million in the third quarter, and average balances on new deposit accounts opened during the quarter are estimated at $43 million compared to $40 million in the third quarter. Moving to interest rates. Our average fourth quarter interest rate for new commercial loans was 6.56%, which is down 11 basis points from the 6.67% average for last quarter. In addition, the fourth quarter rate for all new loans was 6.43%, down 28 basis points from 6.71% last quarter. In closing, as mentioned earlier, we are pleased with our solid performance in the fourth quarter. Our assets continue to reprice upward and deposit growth has allowed us to pay down borrowings. These factors drove our net interest income up $1 million versus last quarter and up $4.6 million versus the fourth quarter of 2024. The combination with Olympic Bancorp and its subsidiary, Kitsap Bank, will add to this positive momentum. We look forward to having the exceptional bankers at 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 Jeff Rulis with D.A. Davidson.

Jeff Rulis, Analyst

Appreciate that Slide 28. The Slide 28, I think, outlined a pretty good outlook for your adjustable rate opportunity. It looks like within the next year, almost a 200 basis point potential there if repriced. I mean maybe, Don, if you could kind of unpack the margin outlook given it looks like you got some earning asset reprice opportunities still to come?

Donald Hinson, CFO

Yes. Thanks, Jeff. Looking back, we had about three rate cuts in the last four months of the year. We were still able to slightly grow our loan yields in Q4. In a quarter where we have rate cuts, we're going to have this balancing where we're repricing our adjustable-rate loans higher while putting on new loans at higher rates. However, the adjustable-rate loans or floating rate loans will be repriced down, those tied to prime or SOFR. In a quarter where we don't have rate cuts, we expect more improved improvement in the loan yields. And then on the deposit side, the cuts help us speed up our deposit betas. But I think we will continue to see some improvement in our costs as well. Overall, this is all without the merger. On the legacy Heritage side, we expect to see margin improvement to continue over the next year or two.

Jeff Rulis, Analyst

Got it. And if I could take that step of incorporating Olympic, it looks like their margin was a little bit lower, but a smaller balance sheet and adding accretion. Any thoughts on the kind of the blended margin moving forward?

Donald Hinson, CFO

Well, I'll preface this by saying that I will get questions about this year as far as the combined margin because we have some fair value work to do once the deal closes. I think their loan portfolio will probably reprice with yields up in the low 6s. Their deposits are already over 20 basis points lower than our cost of deposits. I anticipate that the investment portfolio should reprice probably up into the low to mid-4s, which I think they're at 3 or a little under currently. So I think that we're going to get a nice bump in margin where we could potentially get near that 4% range by the end of the year.

Jeff Rulis, Analyst

Appreciate it, Don. And maybe if I hop over to Bryan, I appreciate the commentary on getting back to normal on payoffs. Is that historical rate kind of a mid- to high single digit? Is that what we could expect absent the balances from Olympic?

Bryan McDonald, CEO

Yes, Jeff, that would be the short answer. Looking at the pipeline at the end of the fourth quarter, the $468 million, we have good visibility near-term. I would say low single digits is our estimate for Q1. Then I would expect that to move to upper single digits based on what we're seeing from the customer base and loan demand heading into 2026. The pipeline has been increasing since year-end.

Operator, Operator

Our next question comes from Matthew Clark with Piper Sandler.

Adam Kroll, Analyst

This is Adam Kroll on for Matthew Clark. Yes. So Bryan, I think last quarter, you mentioned having a few chunky loans you expected to pay off in the fourth quarter. Just wanted to check if any of those got pushed to the first quarter? And just digging more into the loan growth guide in '26, what industries or geographies do you expect to drive that loan growth?

Bryan McDonald, CEO

Yes. The bulk of the payoffs we were anticipating did come through. The payoffs were a little over $170 million for the quarter, which was the highest quarter of the year. For the total year, it was more like $540 million, around $45 million a month. We think that's going to moderate based on our current visibility, potentially one-third less. Last year, we had net advances on loans fall $81 million versus 2024, where they were up $153 million. So we've cycled through that, and I think we should also see net advances move up modestly in 2026.

Adam Kroll, Analyst

Got it. That's great to hear. And maybe switching to expenses. How are you thinking about operating expense growth, both on a legacy Heritage basis for '26? And just what's a good starting point for pro forma 2Q expense run rate?

Bryan McDonald, CEO

Sure. Don, do you want to take that?

Donald Hinson, CFO

Yes. We expect approximately $20 million to $21 million in merger-related expenses. Our conversion is not expected to take place until sometime into September. So we'll maintain a large number of employees until then, with a reduction expected after that. The run rate for Q2 and Q3 will probably be in the 56% range, maybe 56% to 57%. We'll see more of our cost savings in Q4, and the core will probably be down to around $54 million after that.

Adam Kroll, Analyst

Got it. And then just last one for me. I'd like to get your updated thoughts on crossing the $10 billion asset threshold and just what inning you're in in terms of making the necessary investments to cross that $10 billion mark?

Bryan McDonald, CEO

Yes, sure. Let me take the second part of your question first, just in terms of preparedness. We did extensive planning back in 2023 when we were about $7.7 billion in assets, feeling that we had three to four years. We've been making progress on that plan. Since then, with our deposit outflows in 2023, we felt like we had a little bit of additional time. We've been making progress on that and have a good view into what the requirements are. In terms of when we cross the $10 billion, our focus now is on integrating Olympic and ensuring all aspects of that go as planned. On an organic basis, we're several years out from crossing the $10 billion mark.

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 start out on the margin, specifically loan yields. You guys already touched on the fixed repricing benefits to loan yields a little bit earlier. I was just wondering if you could kind of give some color on what you're seeing on the competition front in your markets? It looked like origination yields stepped down a little bit quarter-over-quarter.

Bryan McDonald, CEO

Yes, sure, Jackson. On commercial loans, the new loan production was at 5.56% during the quarter, and the total was at 6.43%. That was down a bit over Q3. Some of that was due to the drop in short-term rates; any variable rate loans we have naturally come in lower. Yes, it continues to be a competitive market for the clients we're targeting, and that's typical. So we're not seeing any outsized competition. It's just very competitive for the type of clients we're after.

Jackson Laurent, Analyst

Got it. That's helpful. And then just on the deposit cost front, it sounded like there might be some positive carry forward into the first quarter. Last quarter, you mentioned around $1 billion of exception price deposits that were sitting around a 3% rate. Just wondering where that bucket is and where that is priced today? And also how much room you have left on the deposit repricing front?

Bryan McDonald, CEO

Don, do you want to take that?

Donald Hinson, CFO

Yes. We're still at about the same level of exception priced deposits, but overall cost at year-end was about 270 million dollars. We also have around 100 million dollars in floating rate public deposits that could decrease if there were rate cuts. Our December cost was lower than for the quarter by about 4 basis points. So we expect costs to keep coming down.

Jackson Laurent, Analyst

Got it. That's helpful. And then just lastly, with closing the Olympic transaction coming up, could you update us on capital priorities in 2026?

Bryan McDonald, CEO

Sure. The first priority is closing the transaction, which will use about 100 basis points of capital. We will look into other uses as we progress, as we get through the fair value assessment and know what our balance sheet looks like. There could be buybacks or potential additional actions, but we are not planning any at this point. I would say buybacks could be a possibility if we find that dilution is less or if the accretion is lower from the deal. We'll evaluate that after the deal closes at the end of the month as well.

Operator, Operator

Our next question comes from Liam Coohill with Raymond James.

Liam Coohill, Analyst

It's Liam on for David Feaster. I wanted to touch on some of the impressive interest-bearing demand deposit growth you saw in the quarter. Could you discuss some of the initiatives you've been using to see success there? Is it mostly granular wins across the franchise?

Bryan McDonald, CEO

Yes, Liam, it is. It's a continuation of what we've been doing throughout the bank's history, focusing on relationship banking and high service quality delivery. We added significantly to our deposit sales team over the last several years, leading to new relationships from these investments. Slide 11 in the investor deck has detailed information. Back in 2022, we added three teams with two-thirds of that group being deposit-generating staff. We also opened several new locations, both in Oregon and Boise, and we continue to see growth from those efforts.

Liam Coohill, Analyst

Great. One more for me. On the credit side, are there any underlying trends or industries you're watching more closely? Regarding the couple of C&I downgrades in the quarter, were those idiosyncratic or were there any commonalities?

Tony Chalfant, Chief Credit Officer

Yes, sure. There was really no correlation between those two deals. They're in separate industries and don't reflect any ongoing trends. The big question regarding tariffs and similar impacts is also not relevant here. So there isn’t anything alarming that we're monitoring more closely at this time.

Operator, Operator

Our next question comes from Kelly Motta with KBW.

Kelly Motta, Analyst

As we look ahead, your efficiency ratio for the past couple of years has hovered in the mid-60 percentage range. You did a bunch of things with the securities loss trades and such expense savings to mitigate some profitability headwinds. Now with the increased scale from Olympic, how do you think that helps generate potentially better efficiency ahead?

Bryan McDonald, CEO

Thank you for the question. I'll have Don start, and then I'll share some comments afterward.

Donald Hinson, CFO

We will gain overall efficiencies between the two organizations. Our efficiency ratio will continue to improve over time, mostly driven by revenue rather than expenses. We're looking to maintain our expense base at a good level. Bryan, do you want to add anything about the overall efficiencies?

Bryan McDonald, CEO

Yes, I would add that we've had a big increase in our margin year-over-year. We see potential to reach that margin around the 4% range in the near term. The combination with Olympic is bringing a significant amount of low-cost deposits, which should positively impact our efficiency ratio. We will continue to focus on methods to scale the company without adding significant costs and on ways to manage our expense run rates. The outlook is positive given what's happening with asset repricing and loan growth.

Kelly Motta, Analyst

Got it. Lastly, with Olympic on board, have there been any updates on M&A conversations?

Bryan McDonald, CEO

Certainly. Our primary focus is on ensuring a successful integration with Olympic, which is our top priority for 2026. However, we continue to engage in conversations as we always have, to be a known party for other banks that may consider partnering with someone. So there are no significant changes in our approach to M&A, and we continue to have those conversations, but our main focus remains on successfully integrating Kitsap.

Operator, Operator

Thank you. At this time, we have not received any further questions. I'll hand the call back over to Bryan for closing remarks.

Bryan McDonald, CEO

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

Operator, Operator

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