Ladies and gentlemen, thank you for standing by, and welcome to the Heritage Financial Third Quarter Earnings Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. [Operator Instructions]. As a reminder, this conference is being recorded. I’d like to turn the conference over to President of Heritage Financial, Jeff Deuel. Please go ahead.

Thanks, David. Good morning and welcome to all who called in and those who may listen later. This is Jeff Deuel, President of Heritage Financial and CEO of Heritage Bank. Attending with me are Brian Vance, CEO of Heritage Financial; Don Hinson, CFO; and Bryan McDonald, Chief Operating Officer. Our earnings press release went out this morning in a pre-market release, and hopefully you all had an opportunity to review that release prior to this call. Please refer to the forward-looking statements in the release. It has been a good quarter for us as we continue to make progress with the integration of Puget Sound Bank and we prepare for the upcoming conversion of Premier Commercial Bank in early November. We are pleased that our core operating metrics continued to show nice improvement from prior quarters. We’re also pleased to announce we’re increasing our regular dividend to $0.17 which is an increase of 13.3% from the 15% dividend in the prior quarter, and that we have declared a special dividend of $0.10 a share. Don Hinson will now take a few minutes to cover our financial statement results, including color on our core operating metrics.

Thanks, Jeff. We saw continued improvement in core operating metrics in Q3 for both linked quarter Q2 2018 and from prior year third quarter 2017. Reported earnings per share for Q3 was $0.42 which is an increase of $0.07 from $0.35 for both the prior year Q3 2017 and the linked quarter of Q2 2018. Q3 2018 earnings were negatively impacted by $0.07 due to $3.4 million of acquisition-related expenses from the Puget Sound and Premier mergers which after tax is an income impact of 2.7 million. Adjusting for the net income impact of these expenses would bring our Q3 EPS to $0.49 compared to reported earnings per share of $0.42. In addition, adjusting for the $2.7 million net income impact of these expenses would bring our return on average assets to 1.37% versus a reported 1.17% and our return average tangible common equity to 14.48% versus a reported 12.77%. Moving on to the balance sheet. We had total asset growth of 487 million in Q3. We acquired assets with the fair value of 387 million during the quarter as a result of the Premier merger which closed on July 2nd. Net of the 330 million of loans obtained in the Premier merger, loans decreased 9.8 million in Q3. We continue to experience unusually high loan prepayments and Bryan McDonald will fully discuss prepayments and loan production in a few minutes. Net of the 319 million of deposits obtained in the Premier merger, deposits grew 110 million or 11% on an annualized basis for Q3. Moving to day one impact of the Premier merger, noninterest-bearing demand deposits grew 52.9 million or 18.1% on an annualized basis and overall non-maturity deposits grew 122 million or 13.9% on an annualized basis. Noninterest-bearing demand deposits increased to 29.8% of total deposits at the…

Thanks, Don. It’s Jeff again. I just wanted to interject that Don misspoke earlier when he was presenting the earnings overview that return on average tangible common equity would adjust to 4.98% as opposed to the 4.4 – I’m sorry, that’s 14.98% as opposed to 14.48% that Don mentioned. And I should say it’s usually Don who’s correcting me, so thank you. I’ll pass it to you now, Don.

Okay. Thank you. Again, this is Bryan McDonald. I’m going to give an update on our third quarter lending results by production area starting with our commercial lending group. In the third quarter, our commercial teams closed 196 million of new loans which is down slightly from 199.8 million closed in the second quarter of 2018 and up from 159 million closed in the third quarter of 2017. Commercial team pipelines ended the third quarter at 335 million which is down from 430 million last quarter and up from 312 million in the third quarter of 2017. Demand for construction and real estate loans remains oversized in the market relative to other loan categories and we continue to manage real estate loan levels to stay within our self-imposed concentration limits. Pricing continues to be very aggressive across all loan types and during the third quarter we saw more instances of aggressive loan structures being offered in the market, particularly on commercial credit. Net loans decreased 9.8 million during the third quarter due to an elevated level of prepayment and payoff activity. Loan payoffs and prepayments during the quarter totaled 167 million which is 57 million or 52% higher than the prior six-quarter average. Similar to last quarter, payoff and prepayment activity was elevated by a higher level of business and real estate sales, customers using cash to pay off debt along with several clients paying off loans after we elected not to offer renewal terms at maturity. Average third quarter interest rate for new commercial loans was 23 basis points higher increasing to 5.43% versus 5.20% last quarter and rates are up 26% in the last year or 113 basis points from 4.3% in the third quarter of 2017. In addition, as Don mentioned, the average third quarter rate for total loans was 5.49%. SBA 7a production in the third quarter included 15 loans for 7.5 million and the pipeline ended the quarter at 20.6 million. This compares to the third quarter of 2017 when we closed eight loans for 2.08 million and the pipeline ended the quarter at 14.8 million. Consumer production during the third quarter was 49.7 million, down from 55.9 million in the second quarter of 2018 and 60.7 million in the third quarter of 2017. We saw strong direct consumer loan demand with volumes up 22% quarter-over-quarter but this was more than offset by a 25% decline in our indirect lending business. The mortgage department closed 44.4 million of new loans in the third quarter of 2018 compared with 38.1 million of new loans in the second quarter of 2018, and 39.8 million in the third quarter of 2017. The mortgage pipeline ended the quarter at 41 million, down from 47 million last quarter and up from 29.1 million in the third quarter of 2017. I’ll now turn the call back to Jeff.

Thank you, Bryan. I just wanted to cover a few general observations. We continue to be comfortable with the overall Pacific Northwest economy. Valuations are stable for CRE and single family. However, competition continues to be strong in all loan segments. In spite of the positive economic environment in the region, we continue to be cautious about all loans segments relying on our robust concentration management process to provide guidance. Currently, our non-owner occupied CRE concentrations are around 260% compared to regulatory guidance of 300%. This provides us with flexibility while we continue to be disciplined in this area of focusing more on loan quality and yield. While our overall loan growth in Q3 was buoyed by the addition of Premier, our organic loan growth was flat quarter-to-quarter due to higher than normal payoffs as customers sold businesses, properties and paid off loans with idle cash which meets the good work done by our production teams. I think it’s important to note that our risk profile also controls our loan growth. In contrast to the flat loan growth, our ability to manage NIM is contributing to our positive performance overall. And although we have seen a higher than normal level of payoff, the new loans we have originated are booked at higher rates. Also now that we are passed the distraction of the Puget Sound Bank conversion which occurred in May, we can see that team contributing in a significant way. The Premier conversion is just around the corner in early November and we believe we are teed up for another good conversion, thanks to the hard work of our project team. Once that is behind us, we expect to see the Premier team start to contribute to the pipeline in a bigger way much like we saw with the…

Thanks, Jeff. Just some overall observations from my point of view. I’m happy with the positive progress we have made in the third quarter and I’m pleased to see Heritage benefit from the larger scale of the combined organization. We believe the benefit of scale will continue to accelerate after the Premier conversion. We believe our continuing and historical high prepayment activities signal in part a natural occurrence of this economic cycle where folks are selling assets and taking profit. We have considerable evidence of loans paying off as a result of assets and businesses selling. We also have substantial anecdotal evidence from our branches indicating some deposit growth is attributed to homes, commercial real estate and businesses selling and large deposits being made as a result. We also believe our NIM expansion in part is due to our unwillingness to be a low cost provider in the form of rate competition. As many banks have recently struggled to get loan growth, we are finding renewed activity of highly competitive rate pricing of new loans. Our loan growth has also been impacted in part by competitive and aggressive underwriting considerations. We believe that again at this point in the economic cycle that underwriting discipline is critically important to future credit quality and financial performance. And as rates continues to increase, the quality of our overall deposit base and relative lack of leverage in our balance sheet will continue to favorably impact our deposit betas. We remain committed to maintaining a liquid balance sheet. And finally, it is pleasing to see the improving trends in ROA, EPS, ROE and our overhead ratio. These metrics signal to me the leadership team is continuing to effectively manage the bank while we expand our footprint and grow the bank. David, I’ll turn the call back to you. We’d welcome any questions you may have. And once again we’ll refer you to our forward-looking statements in our press release as we answer the questions and dealing with any forward-looking comment.

[Operator Instructions]. Our first question will be from the line of Jeff Rulis with D.A. Davidson. Please go ahead.

A question on the prepayment front. I got sort of the impression that this came on later in the quarter. In discussions it seemed like payoff activity was sort of at bay relative to 2Q I guess through midway to the third quarter. With the averages balances kind of skewed with the deal, is that payoff activity more heavier on the back end of the quarter?

Jeff, this is Brian. No. We had elevated payoff activity in the second quarter and that continued into the third and all the way through the third. We were hoping it might abate as we got towards the tail end, but didn’t see that happen. So it was pretty consistent throughout the quarter. Of course, payoffs are choppy anyway. Obviously they are a regular occurrence but the size of the underlying loans do drive some variability, but the activity itself was consistent through the quarter.

And the comments on kind of the timing [ph] distraction through I guess the Puget Sound folks, you saw that immediate ramp two to three months after the close. Is that kind of timing consistent with what you’re expecting kind of in Q4?

Jeff, it’s Jeff Deuel. We never – we didn’t see the Puget Sound team stop completely. We did see them slowdown on their production because they were focused on retaining the customers that we had. But once the conversion occurred, we started to see a more full focus on the production side. I still think they’re barely getting to 100% but they’re moving quickly at this point. A fun fact is if you look at the production numbers for the top 20 producers in Heritage Bank, eight of them are in that office. So we’re seeing some really good results there.

And one other one just on the – just looking for some expense detail, maybe it’s for Don or anyone I guess. Post conversion I guess if you look at 39.6 million in expenses less the merger cost puts you in the low 36 range. Through conversion I don’t know if you could broadly walk us through what you expect in Q4 and then in '19?

Well, I think as Jeff mentioned in his comments that we continue to – I’ll talk to it from an overhead ratio, the noninterest expense over average assets that we continue to look to lower that on an ongoing basis. So we – again, when I talk about backing out the impacts of the merger related expenses and backing out the CDI amortization that we were at 2.64, and so we’ll just continue to look to improve upon that. Always I would say that’s a long-term trend. We always have -- Q1 is always a little bit of a blip up, but overall year-over-year and an ongoing trend to improve upon that. So I guess that’s how I’d answer that is that ratio is expected to continue to improve.

Okay. Obviously that pulls in another variable on your asset growth I suppose. But in other words if we back into the core this quarter outside of your comments about Q1 always a step up, that’s a pretty solid figure going forward assuming reasonable growth.

Yes.

Okay. Thank you. I’ll step back.

And the next question will come from the line of Matthew Clark with Piper Jaffray. Please go ahead.

Hi. Good morning.

Good morning.

Maybe just to pin you down a little bit more, Don, I think last quarter you spoke about trying to achieve that 265 to 270 range for the overhead ratio by the end of the year. Clearly in line with that, but I guess as you look out to next year I think we’ve talked about in the past maybe sub-260 in 2019 and maybe better beyond. How should we think about that progression with your commentary around kind of continued improvement?

Well, again I think that some of the previous comments I’ve made didn’t kind of back out the impact of the amortization. So I think going forward, I’ll probably talk more about that because it’s kind of one of those costs that aren’t really controllable. So I would say, again, this year I’m looking at Q4. That’s probably the low 260s. And next year they’ll bring us for the year probably in the 270 range or between 265 and 270. Again, each year the whole idea here is to continue to improve upon every year whether it’s the quarter’s year-over-year or move forward. But again there can be blips in a quarter like I mentioned a Q1 can always – is always more costly but overall just continued improvement and yes, hopefully we’ll be down – by the end of next year down to 250s. So that’s the progression we’re looking at.

And again that’s excluding now amortization?

Correct.

Got it, okay. All right. And then just with all the payoff activity I guess how much did, if at all, prepayment penalty income contribute to the margin this quarter versus last?

Matt, Don’s looking but we follow each one of the payoffs anything over 500,000. We get comments back from the banker and actually see the payoffs. And there wasn’t significant prepayment impact. Don, I don’t know if you have the number on that handy.

I don’t think it was really material, Matt, on that.

Okay, just double checking. And then just on the full year loan growth guidance or maybe just 6% to 8% kind of targeted range that you guys look to do; obviously, flattish to down this quarter organically. I guess based on the pipeline being down and I guess your outlook for Premier stepping up here eventually, I guess how do you think about that range of growth going forward whether it’s the fourth quarter or into next year?

Matt, we’ve talked historically about 6% to 8% growth. Obviously that’s not occurring when you look at the whole year. Based on what we see in the second quarter and the third quarter with payoffs, we don’t see that abating. We would like to hope that it will. It’s not necessarily something we can control because it’s not necessarily related to customer service, for example, or unmet needs on the part of our customers. They’re making these decisions on their own. Right now we’re expecting the loan growth to continue to be as it has been in the last couple of quarters, relatively flat. So we’re totally well below the 6% to 8%. Don, you may want to add to that in terms of expectations for next year for loan growth.

Yes, that’s be – again below that. And so maybe trailing12 quarters are now around 5% or below that. So it’s going to be – for this year it’s going to be tough to hit that.

I think Matt to give you guidance for next year I think we need to see how the rest of the quarter goes.

Yes, understood. Okay. Thank you.

The next question comes from the line of Jacque Bohlen with KBW. Please go ahead.

Hi. Good morning, everyone.

Good morning.

Don, do you have the breakout between comp, professional fees and data processing in terms of the acquisition expenses in the quarter? I’m just trying to see the core run rate for those.

Yes. Most of it was in compensation. And we didn’t have that much – well, actually we did. We did have about $1 million professional fees in Q3 was part of that. So the rest of it was comp and data processing.

Okay. Thank you. That’s helpful. And were cost savings realized in the quarter or are most of those waiting until the conversion?

For Premier, most of that will happen after Q4.

Okay. And then just lastly and I guess the special dividend kind of almost answers this question, but just how you’re thinking about capital management? I know you have an authorization now for buybacks and there’s market volatility and everything and potential M&A. Could we just have an update on how you think about dividend versus buyback versus M&A?

Jacque, it’s Brian. I think that if you look back to the start of the year and we’ve done two acquisitions and we owned a bank over the – on a year-to-year basis by some $1 billion in assets combined, I think I would have told you that I will be surprised that our capital has actually grown now as a result of working through that growth and those acquisitions. Now obviously we were issuing stock as a part of that. But my point is, is that I think that we’re beginning to generate some pretty nice internally generated capital and that’s showing through the actual TCE growth. So I think that as we continue to look to 2019 and I think at this point we like the progression of most all of our operating metrics whether they’re ROA, ROE, expense control, et cetera, that I think we believe that there’s a good chance that internally generated capital is going to continue to grow which I think will fuel not only organic growth but future M&A growth. So I think our overall capital position is strong and we hold it at that level probably intentionally for both the organic growth and M&A growth. M&A growth is hard to predict. We’ve been successful the last year. We continue to be active in that arena going forward in terms of just discussions, et cetera, but it’s hard to predict when. But we believe that we’ve got sufficient capital to support not only growth in regular dividends but as I said a moment ago organic growth and M&A growth.

Okay. And was there any specific driver of the special dividend this quarter or was it just – you had really strong capital levels and wanted to reward shareholders?

I think that’s probably a fair statement, Jacque. Don, correct me. We’ve done a special dividend each of the last six years now?

Yes, seven.

Seven years now, so I think there’s a pretty consistent special dividend payment payout on our part. It’s varied from year-to-year. I think the last few years it’s been $0.10. And I think that we’ve used that special dividend to kind of manage the TCE to keep it at least steady and not to grow it beyond where it is. And so it will continue to be variable because it’s not always easy to predict exactly what growth, et cetera, where it will be. But yes, I think your general statement is true.

Okay, great. Thanks for the added color.

Sure.

[Operator Instructions]. We have a question from the line of Tim O’Brien with Sandler O’Neill. Please go ahead. Tim O’Brien: Thank you. Two questions for me. Don, do you have a budgeted number for conversion costs or remaining residual deal-related cost that you expect to book in the fourth quarter?

Tim, I’m expecting somewhere between 500,000 and 1 million. Tim O’Brien: Okay, great. And then secondarily, tax rate 16.3% effective this quarter. That’s pretty close to what you guys were guiding on a run rate basis. Any adjustments in thinking around what your tax rate might be here going forward on a sustainable basis?

I think it’s going to increase a little bit over time as we are no longer really buying municipal bonds anymore due to the tax rate and their prices. So I think some of our tax-exempt securities will fall off over time. And because we’re not adding to it also, the percentage of cash exempt of assets will go down compared to other assets. And so I think it will be creeping up over time. So 16.3 is – which will probably go up little by little for every quarter. Tim O’Brien: Great. And then last question kind of bankers question, existential question. Given all the color that we’ve heard from you guys about the challenging lending environment and I guess excessive risk taking in underwriting and loss of deals, prepayments, that sort of stuff on the lending side, would you characterize this market in terms of what your bankers face as being more challenging in terms of gathering good high quality loans or deposits at this point?

I don’t think it’s necessarily any more challenging than it has been, Tim. I think that what you’re seeing is that we’re continuing to just be disciplined about how we approach the market. There’s lots of opportunities for us to do CRE business or non-owner occupied CRE. We’re trying to focus on the owner occupied which comes with the relationships and saving our firepower for the relationships that are related to non-owner occupied. Bryan, you might want to add some color as well.

Yes, I’d agree. I guess I’d start, Tim, just by saying when I look at the sales force that we have today, it’s by far the best group that I’ve been involved with in my career. And look at the distribution in the markets we operate in, that’s just terrific; the customer base, the distribution network, all very strong. So I feel really well positioned. And then when we look at the new production activity in the second and third quarter, it was good. It was really quite good. And so really it’s this payoff activity and it’s not related to losing clients. It’s just clients making decisions to sell an asset or sell a business. So if we were losing clients, I’d be – I’d feel differently about it but that isn’t the case. These folks are going to come back and continue to do business with the bank. The competitive side is in the pipeline activity and competing in the market for business, it’s as Jeff said always a competitive marketplace. We’ve seen that tick up a level on the pricing side and the structure side and that’s having an impact. But in spite of that, our production is strong. So we see the payoff requests and we’ll hear a customer selling a piece of property and netting a nice profit on it, and Jeff and I say, well, that seems like a good business decision and we’ll get the chance to do other business with them down the road. We are keenly focused on deposits as well all across the platform and we’re seeing good results from that. So overall I wouldn’t say uncomfortable with where we sit.

Tim, Brian just made the comment about how we probably one of the best production teams that we’ve ever had and they’re placed in the right spots. When you hear about the business origination that we do have both for loans and deposits, it’s coming from the parts of our footprint that you would expect. It’s coming from that Seattle-Bellevue metro area, the Portland market as well as some of the legacy Heritage markets like Pierce County where Tacoma is and even in Thurston County where we’ve been for 91 years. Tim O’Brien: Thanks for all the color, guys, much appreciate it.

At this time, there are no further questions in the queue.

Okay. Thank you, David, and thank you everyone for calling in. And I’m sure we’ll be crossing paths over the next quarter. Thank you.

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