Ladies and gentlemen, thank you for standing by, and welcome to the Heritage Financial Fourth Quarter Earnings Call. At this time, all the participant lines are in a listen-only mode. There will be an opportunity for your questions, and instructions will be given at that time. [Operator Instructions] As a reminder, today's call is being recorded. I'll turn the conference now to Mr. Jeff Deuel, CEO. Please go ahead, sir.

Thank you, John, and good morning to everybody on the call. Welcome, and welcome to those who may call in later or listen in 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, COO. Our earnings press release went out this morning pre-market, and hopefully you've had an opportunity to review it prior to the call. Please refer to the forward-looking statements in the press release. It has been a good quarter for us as we continue to make progress integrating Puget Sound Bank and Premier Community Bank. We completed the conversion of Premier in early November, so both banks are now on our core systems. In addition, we recently announced a new team of bankers in Portland, who joined us in early January. We're pleased with our core operating metrics as they continue to show nice improvement from prior quarters. We are also pleased to announce that we are increasing our regular dividend to $0.18, which is an increase of 5.9% from the $0.17 regular dividend in the prior quarter. Don Hinson will now take a few moments to cover our financial statement results, including color on our core operating metrics.

Thank you, Jeff. Although there was some noise in our numbers this quarter, we like the continued improvement in our core profitability metrics. Reported earnings per share for Q4 was $0.45, which is an increase of $0.03 from Q3. Q4 earnings were negatively impacted by $0.02 due to $1.3 million of merger-related expenses from the Puget Sound and Premier mergers. Adjusting for the net income impact of these expenses would bring our Q4 earnings to $0.47. In addition, Q4 was impacted by adjustments to income tax expense, which negatively impacted earnings by about $0.03. I'll review this further in a few minutes. Although we did not have significant balance sheet growth in Q4, we did see nice increases in non-maturity deposits. Total non-maturity deposits increased $71 million or 7% on an annualized basis in Q4. Leading the way of this growth was non-interest bearing demand deposits, which increased $50 million or 15% on an annualized basis. Overall deposit growth was muted by a decrease of $36.7 million in CDs, which was due mostly to the maturity and non-renewal of $30 million of brokered CDs. Due to continued high prepayments loan growth was muted in Q4. Bryan McDonald will further discuss prepayments and loan production in a few minutes. To offset the lack of loan growth, we purchased additional securities resulting in an increase of $55 million of investments during Q4. Overall credit quality improved in Q4, with reductions in nonperforming loans and potential farm loans. The ratio of our allowance for loan losses to nonperforming loans stands at a very healthy 256%, up from 233% in the prior quarter. In addition, included in the carrying value of the loans are approximately $12 million of purchase accounting fair value net discounts which may reduce the need of an allowance for loan…

Thanks, Don. I'm going to provide detail on our fourth quarter lending results by production area, starting with our commercial lending group. In the fourth quarter, our commercial teams closed $187 million in new loans, which is down from $196 million of new loans closed in the third quarter of 2018, and up from $161 million closed in the fourth quarter of 2017. New production during the fourth quarter was centered in King County at $82 million, with Portland, Pierce County, and Northwest regions each contributing $22 million. Commercial team pipelines ended the fourth quarter at $340 million, which is up from $335 million last quarter. Largest concentration of the pipeline is in King County and Portland, which comprise $196 million and $77 million respectively. Net loans increased only $5.1 million during the fourth quarter due in part to a continuation of the higher prepayment, and payoff activity we have been experiencing since the second quarter of 2018. Loan payoffs and prepayments during the quarter totaled $140 million versus $167 million in Q3, a $152 million in Q2, and $109 million in Q1. 2018, average payoffs per quarter at $142 million represents a 43% increase as compared to the 2017 average of $99 million per quarter. This compares to a 28% increase in loan balances during the same period. Similar to the last two quarters, payoff and prepayment activity in the fourth quarter was elevated by a higher level of business and real estate sales, customers using cash to pay off debt, and clients paying off loans due to our active portfolio management efforts. SBA 7(a) production in the third quarter included nine loans for $7 million in the pipeline end of the quarter at $25 million. This compares to last quarter where we closed 15 loans for $8 million and the pipeline ended the quarter at $21 million. Consumer production during the second quarter was $49 million relatively flat with $50 million last quarter. The mortgage department closed $28 million in new loans versus $44 million last quarter and $36 million in the fourth quarter of 2017. The mortgage pipeline declined primarily due to seasonal factors and ended the quarter at $23 million, down from $41 million last quarter and $27 million in the fourth quarter of 2017. Moving to interest rates, average fourth-quarter interest rate for new commercial loans, was 19 basis points higher, increasing to 5.62% versus 5.43% last quarter, and rates are up 23% in the last year or 105 basis points from 4.57% in the fourth quarter of 2017. In addition, the average fourth quarter rate for all new loans was 5.66%. I'll now turn the call back to Jeff.

Thank you, Bryan. I'd like to add some general observations. We continue to be comfortable with the overall Pacific Northwest economy. Evaluations 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 our region, we continue to be cautious about all loan segments relying on our robust concentration management process to provide guidance. Currently, our non-owner occupied CRE concentrations are at 258% of capital compared to 263% in the last quarter and construction is at 39% capital compared to 44% last quarter. Operating at these levels provides us with flexibility and also allows the bank to take advantage of high quality opportunities while still being able to maintain discipline focusing on loan quality and yield. As you can see, our concentrations in certain categories are opening up a bit due to the ongoing payoffs. Our overall loan growth in Q4 was flat quarter-to-quarter due to higher than normal payoffs, which again muted the good work done by our expanded production teams. I think it's important to note that our risk profile overall also limits our loan growth to a certain degree. As you know we experienced pressure from loan payoffs for the last three quarters of 2018. 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 being booked at higher rates. Also now that we are past the distraction of two conversions in 2018, we can see that the acquired teams contributing in a more significant way as the pipeline builds, and we are happy to be seeing the benefits of our larger scale following the integration…

Thank you, Jeff. As I reflect back on 2018 and the two mergers we closed and integrated, I'll remind that we grew our assets by 29% year-over-year. This growth is a significant accomplishment, especially considering that we integrated two banks and executed two successful conversions all in one calendar year. I would like to thank our experienced and capable bankers, and especially the back office teams of our organization that we do not sufficiently talk about in these calls. They were all rock stars this past year. Jeff and others have talked about the prepayment activities that continue to plaque us and many other banks, prepayments for the most part are uncontrollable, but we do have a greater control over the production of new loans, and we are pleased with the production numbers and our prospects for 2019. We are pleased with our core net interest margin expansion, but we are also cautious about the pace of NIM expansion going forward due to increasing competitive deposit pricing, which we are beginning to see more of. I would like to reiterate a data point that Don mentioned and highlighted, and that's our continued growth in DDA deposits. Since 2015, we have had compounded annual growth rate of non-interest bearing deposits of 21%. In Q4, we still grew DDA deposits by an annualized rate of 15%, at a time when DDA deposits across the industry are being moved to higher-yielding interest bearing products. As Jeff as noted, loan growth has and will likely continue to be impacted by our overall risk profile. We have never sacrificed loan quality for loan growth, and we are not going to start now, especially at this point in the cycle. I continue to believe that on balance sheet liquidity along with credit quality will set-up our strong performance from the rest of the pack as we head into more challenging interest rate and overall economic environments. I'm pleased with our historic performance in these two areas. Now, I would like to turn the call back to Jeff for closing comments.

Thanks, Bryan. I'd just like to conclude our update with the comment that overall we feel very good about what we accomplished as an organization in 2018, and we're looking forward to taking advantage of all the great opportunities that are in front of us for 2019. So, John, with that, we're ready to open up the call now for questions that anybody may have.

Certainly. [Operator Instructions] And first go to the line of Jeff Rulis with D.A. Davidson. Please go ahead.

Good morning, Jeff.

Good morning. Yes, I guess a question on the payoff activity just to kind of get in there a bit, Jeff, you mentioned a bit of that, and I guess Bryan alluded to it as well, just kind of the risk profile and how much is partly on your end kind of forcing it out or trying to stick to concentrations. Is there another way to interpret the payoff level to say, look, we have increasingly driven more payoffs from forcing out versus kind of what's been payoff, is there a way to kind of gauge if you've been more active in pruning the portfolio versus just straight payoffs?

Yes, I think there's a way to do that, and I think Bryan McDonald may want to add to this, but we went through our analysis of the numbers, and I think we could probably point to less than 10% of the payoffs were related to us actively managing the portfolio, which we've always done. It's just that it is a part of the function of the payoff process, but a good portion of it is also just general activity with our customers, and if we tracked the payoff activity you'd see any number of reasons why they're being paid off. And in some cases, we may be just waiting for the next shoe to fall and then the next loan to come back to us. Bryan, anything you'd like to add to that?

The only thing I'd add on to Jeff's comments is, with the competitive environment that we're in, if we're even a little less than accommodative even on the lower quality credit they immediately refi out, and so, that's been an trend we've seen last year, but it's really accelerated this year. So, it's easier to move out anything at this point in the cycle.

Helpful, thanks guys. And just on the expense run rate then, I guess you're kind of pointing to a $36 million base if you back up the merger stuff this quarter, how does that look for -- is that a good number, I guess, to grow off of in '19?

Well, I'm sure Don will want to jump in on this, but I think the way that we tend to present our view on the run rate or the expenses is where we're going to come out on our overhead ratio, and Don has been pretty consistent with his response to this question, that it's in the 2.6 range by the end of the year. We tend to see our expenses maybe expand a bit at the beginning of the year, and then we work real hard to bring them down by the end of the year. So Don, you want to add to that?

Sure. Again, I think year-over-year we're always looking for overhead ratio improvement. We've had, I think in the Q1 we always have a little bit of uptick due to things like payroll taxes increasing in Q1 and some other things that tend to happen. I would say also, we just did hire a new team and that impact will be -- Q1 will be the first quarter on that. So I think that, again, our overhead improved I think for year-over-year even with the teams, and other investments we're making on the technology side, and other production people we brought on this last year, some later in the year. So I continue to see that we'll improve that overhead ratio, but there are other investments we're making that are going to slow down that improvement.

And Don, I missed your tax rate guidance. What was that number?

The mid to high 16's.

Mid to high 16, okay. Great, thank you.

Thanks, Jeff.

The next question is from Matthew Clark with Piper Jaffray. Please go ahead.

Good morning, Matt.

Hey, good morning. Want to get your thoughts on the loan growth outlook given the teams you brought over, acknowledging the seasonality to some degree in the fourth quarter. As you look out to 2019, does six to eight kind of still feel like the right range this year?

Yes, Matt. I know it sounds familiar to you, but yes, the six to eight percent range is what we would expect to see in the New Year. But obviously that's with a more normalized rate of payoffs, which we can't predict or control. A portion of the response could also point to the added team. Bryan has done some analysis on the Portland team and what their run rate was last year, and that will be at a higher rate obviously, because they're newer. Bryan, you want to talk a little bit about that?

Yes. I would just say we saw the pipeline move up a little bit at the end of Q4. And as was articulated in some of the opening comments, we're really -- with the conversions behind us, we're really focused on supporting the ongoing efforts of the sales team. And so, we'll be looking at focusing all our resources on getting that pipeline growth to continue to move up. As for the new team, over the course of the next few quarters we see them adding to that pipeline down in Portland, in addition to the Premier Banking Group being through the systems conversion which happened late last year, so -- and we're already seeing good results from all those efforts down there in the Portland market.

Okay. And then when we think about that range of six to eight, should we assume the lower end of the range maybe if the curve remains this flat given how difficult it might be to retain business and the competitive pricing with that type of environment or would it be maybe even below that? I'm just curious how you think about the curve and the ability to normalize payoffs.

Yes, the piece we can fold to production site, so we tend to focus on that and the actual net difference between six and eight when you look at it from that standpoint it's hard to get that finite in the analysis, because when you look at the dollars production versus the payoff, it's a small range when you get to those net numbers, but we feel, at the end, if you look at the pipeline down there in Portland at $77 million at the end of the year, with the group of bankers we have down there we could see significant increases down there as we go through 2019. So that's what's really different, say, now than Q4.

Okay. And then just on the deposit pricing pressure, it sounds like you feel like it's increasing. But do feel like -- doesn't sound like there's a meaningful step up necessarily in deposit betas to come. Is that still the right way to think about it, just kind of…

Well, I think anecdotally, Matt, I can point out to you that we're having a lot more conversations about exception pricing for specific situations, and that's just -- using that as an indicator we're having more of those conversations that we were the last quarter. But Don, you probably have some comments you'd like to add.

I think betas will increase some. I don't think they're going to skyrocket, but I think they'll -- we've been keeping them down so well this last year that I think there's always a little bit of lag effect. Of course, when you talk about betas to short-term rates, I don't know if the short-term rate is going to go anywhere. So, I think the betas are definitely going to increase and compared to what the short-term rates are going to do over the next year, so. But as far as the overall rate, I think they'll probably increase more than they have in the past. But I still think that we can still manage them to reasonable levels.

Okay. And then just last one for me, on expenses. Are there any cost-saves left from the Premier deal?

There are a few, but quarter-over-quarter there'll be some cost saves but there are also expenses, again bringing up the new team, and again I mentioned some other technology investments we're making this year that will probably offset a lot of that.

Yes, Matt, another piece to that is that I think as we look back on the two transactions we did, we feel pretty good about achieving the cost saves that we expected to get out of them. But at the same time, in parallel, we have to maintain an overall platform for the organization that keeps up with the growth and the development of the organization. So that's why you're hearing us reference the enterprise risk platform and the IT platform. Those are kind of investments to the side of the two transactions we did.

Okay, great. Thank you.

Thanks, Matt.

The next question is from Tim O'Brien with Sandler O'Neill. Please go ahead.

Good morning, Tim

Good morning, Jeff. So, with the team hire and the branch close do you expect any one-time expense items to impact in 1Q related to those two activities?

I don't see us having any kind of significant one-time expense related to the branch.

No. I think we still have probably $100,000 or $200,000 of, you might say, merger-related expenses left of it to clean up in Q1. So that will probably show up. Other than that there's not a lot out at this point. The branch is related to a lease termination -- that's coming to an end, so there's not really too much to write off there related to that.

And have you guys characterized the savings that you expect, kind of quarterly savings to come from that branch closure. Are you willing to talk about that?

I can't imagine it's a huge number.

Yes, usually these branches, if they're not over the large -- and these aren't because it's probably $200,000-$250,000.

A year?

Yes.

And then are there any one-time costs that you expect to hit in 1Q as a result of the team hire.

No, Tim

Okay. That gets -- okay, very good. And then another question that I have for you is as far as the elevated payoffs are concerned, a different kind of tact on that. The payoffs that were not planned, I guess I'd call it, can you rank reasons behind -- drivers behind those payoffs. Is it business is selling, is it investor-owners selling property at high levels, is it just getting refi'd away due to attractive pricing on new loan elsewhere. How would you rank kind of what the big driver behind the unplanned payoffs is?

I don't think it's a good -- I don't think the last item you brought up, which was refinancing elsewhere is a big component of it. We do see some of that. We always see some of that, but that -- it's not tied to us necessarily losing customers because they're going elsewhere for better rates or better service. It's more along the lines of what Bryan mentioned earlier, is the selling businesses had a big impact in the last year as I think through it. The selling properties at high prices is also another big one, Tim. And then there's a category of miscellaneous stuff, it's a piece of property that's been on the market for two years and it finally sold or it's partners that are disbanding and they're selling. It's just a category of oddball stuff.

Okay. Those were my two questions. Thanks a lot.

Thanks, Tim.

[Operator Instructions] Next, we go to Jacque Bohlen with KBW. Please go ahead.

Good morning, Jacque.

Hi, good morning. I just wanted an update on your appetite for M&A given that you've completed incredibly strategic deals that expand you exactly in markets you want to be in this year and you've had some great teams coming on, the most recent one in Portland. Does this diminish your forward appetite now that things are kind of integrated and moving, or is it still just continuing to look for strategic opportunities?

We are definitely, still open for opportunities. You know, there is 20 plus banks along the I-5 corridor that are of a size that would be interesting to us. And as we say -- not all of them will sell and some of them are not cultural fits, but if any of them who are - presented themselves were ready to go, I would like to add though that because of the two transactions we did last year, we have some projects that slowed down because of that and we certainly would love to have some time to get those things up and running and moving forward before we do another transaction. The nice thing is, is once a transaction presents itself, we know there's a pretty long lead time on it. So I think before anything could present itself to us and really become something we needed to focus on, it would be later in the year, and we'll have time to do that cleanup.

Okay, and the projects that you referenced, are they more on the expense side or on the revenue generation side?

I would say both. It's less focused on, for example, core system activity, and more focused on us wanting to upgrade or improve the ancillary systems that we use to support our customer activities.

Okay. And these are items that you've already been looking into, but they were just paused with the integration?

Exactly. They were all almost -- yes, actually, all of them were projects that were teed up and in process, but when we do a transaction, let alone two, it kind of takes the capacity out of the system to work on those projects, because we put full focus on the integration and conversion, but fortunately all that's done. Everyone had the holiday season to get rested up from last year, and everybody is back and focused and I'm guessing that about March, people will be wondering where the next big undertaking is which is what we hope for.

Okay. And just from an income statement standpoint, as these projects get underway is there any discernible impact that we'll notice?

I don't think necessarily anything that will jump out at you from an expense standpoint, no.

Okay, great. Thanks for the extra color.

Thank you.

And Mr. Deuel, no further questions in queue.

Well, John, thank you for your help this morning and thank you for everyone who called in. We appreciate the attention and I'm sure that all of us will be crossing paths as the year progresses, thank you.

Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect.