Heritage Financial Corporation (HFWA) Q1 2025 Earnings Report, Transcript and Summary

Hello, everyone, and a warm welcome to the Heritage Financial Q1 Earnings Call. My name is Emily, and I'll be coordinating your call today. After the presentation, you’ll have the opportunity to ask questions. [Operator Instructions] I will now hand you over to Bryan McDonald, President and CEO. Please go ahead, Bryan.

Thank you, Emily. Welcome, and good morning to everyone who called in and those who may listen later. This is Bryan McDonald, President of Heritage Financial. Attending with me are Jeffrey Deuel, CEO; Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer. Our first quarter earnings release went out this morning premarket, and hopefully, you have had the opportunity to review it prior to the call. We have also posted an updated first quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity and credit quality. We will reference the presentation during this call. We are pleased with our operating results for the first quarter, including strong deposit growth, reduced borrowing levels and margin expansion. We are optimistic the combination of our core balance sheet growth and prudent risk management will continue to benefit our core profitability as we progress through 2025. We will now move to Don, who will take a few minutes to cover our financial results.

Thank you, Bryan. I'll be reviewing some of the main drivers of our performance for Q1. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the fourth quarter of 2024. Starting with the balance sheet. Although loan production was similar to the first quarter of 2024, total loan balances decreased $37 million in Q1 due to elevated payoffs and prepayments. Yields in the loan portfolio were 5.45%, which was 2 basis points lower than Q4. This was due primarily to the 50 basis point reduction in the Fed funds rate in Q4, Q1 incurring the full impact of these cuts. Bryan McDonald will have an update on loan production and yield in a few minutes. We had strong deposit growth in Q1 and 95% of this growth was in non-mature deposits. Total deposits increased $160.7 million in the quarter, with the majority of the growth in money market accounts. Unlike the past several quarters, we did not experience much growth in CD balances with the percentage of CDs to total deposits decreasing during the quarter. The movement of balances from non-interest-bearing accounts to interest-bearing accounts shows that customers are continuing to invest excess funds and higher-yielding accounts. The cost of interest-bearing deposits decreased to 1.92% in Q1 from 1.98% in the prior quarter. We expect to continue to see some further decreases in cost of total deposits due to the repricing of CDs. However, we don't expect decreases in the cost of interest-bearing non-maturity deposits absent further rate cuts by the Fed. Investment balances decreased $53.8 million, partially due to a loss trade executed during the quarter. A pretax loss of $3.9 million was recognized on the sale of $61 million of securities. These sales were part of our strategic repositioning of our balance sheet in which a portion of the proceeds was reinvested in $28 million of securities and the remaining proceeds were used for other balance sheet initiatives, such as the funding of higher-yielding loans. Moving on to the income statement. Net interest income decreased slightly from the prior quarter due to less days in Q1 compared to the prior quarter. The net interest margin increased to 3.44% for Q1 from 3.36% in the prior quarter, due primarily to decreases in the cost of both deposits and borrowings. We recognized a provision for credit losses in the amount of $51,000 during the quarter. This small provision expense was due to the decrease in loan balances during the quarter, along with continuing low levels of charge-offs. Tony will have additional information on credit quality metrics in a few moments. Non-interest expense increased $1.8 million from the prior quarter due mostly to higher benefit costs and payroll taxes. We continue to guide in the $41 million to $42 million range for quarterly non-interest expenses this year. And finally, moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds and our TCE ratio was 9.3%, up from 9% in the prior quarter. Our strong capital ratios allows us to be active in loss trades on investments and stock buybacks. Although we did not repurchase any shares under the stock repurchase plan in Q1, we may in the future depending on market conditions and other capital needs. We still have 990,000 shares available for repurchase under the current repurchase plan as of the end of Q1. I will now pass the call to Tony, who will have an update on our credit quality.

Thank you, Don. Through the first quarter, credit quality remained strong and stable. Non-accrual loans totaled just over $4.4 million at quarter end, and we do not hold any OREO. This represents 0.09% of total loans and compares to 0.08% at the end of 2024 and 0.10% at the end of 2023. The increase in the first quarter was a modest $359,000. Page 18 of the investor presentation reflects the stability in our nonaccrual loans over the past three years. Non-performing loans improved from 0.11% of total loans at year-end to the current level of 0.09%. This category now includes only non-accrual loans. We had one C&I relationship that was over 90 days past due at year-end and still accruing that was paid off during the quarter. Criticized loans, those rated special mention and substandard, totaled just over $178 million at quarter end, declining by $1 million during the quarter. Loans in the more severe substandard category were down by 5.7% or $3.9 million. Substandard loans represented 1.4% of total loans at quarter end, consistent with year-end 2024 and lower than the 1.6% we experienced at year-end 2022 and 2023. The credit quality of our office loan portfolio has remained stable over the last 12 months. This loan segment represents $572 million or 12% of total loans, and 52% of these loans by dollar amount are owner occupied. The average loan size is $1.1 million. They are diversified by geographic location and we have little exposure to the core downtown markets. Criticized office loans totaled just under $14.5 million, representing 2.5% of total office loans. Page 17 of the investor presentation provides a more detailed information about our office loan portfolio. During the quarter, we experienced total charge-offs of $376,000 that were split evenly between commercial and consumer portfolios. The losses were offset by $77,000 in recoveries, leading to net charge-offs of $299,000 for the quarter. This represents 0.03% of total loans on an annualized basis and compares favorably to the 0.06% we reported for the full year 2024. While we are pleased with the stability in our credit metrics through the first quarter, we are aware of the emerging risks in the economy. We will be closely watching developments around tariffs, changes in federal funding and other issues that could have an impact on our credit quality. We remain confident that our consistent and disciplined approach to credit underwriting and portfolio management will serve us well in this period of economic uncertainty. I'll now turn the call over to Bryan for an update on our production.

Thanks, Tony. I'm going to provide detail on our first quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $183 million in new loan commitments, down from $316 million last quarter and up from $133 million closed in the first 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 first quarter at $460 million, up modestly from $452 million last quarter and up from $409 million at the end of the first quarter of 2024. Tariffs and other emerging economic uncertainty has caused some of our customers to suspend capital plans, but we have yet to see it substantially impact the loan pipeline. We are watching this closely and believe if the uncertainty persists, more customers may cause spending -- may pause their spending. Loans declined for the quarter by $37 million due to elevated payoffs and prepaid loans. In addition, the mix of loans closed during the quarter resulted in lower outstanding balances. Please see Slides 14 and 16 of the investor presentation for further detail on the change in loans during the quarter. Deposits increased $161 million during the quarter as new business acquisition remains strong. Balances on new accounts opened in the fourth quarter continue to fully fund and seasonal outflows were moderate compared to our typical first quarter. The deposit pipeline ended the quarter at $165 million compared to $141 million last quarter, and the average balance on new deposit accounts opened during the quarter are estimated at $54 million compared to $121 million in the fourth quarter. Moving on to interest rates. Our average first quarter interest rate for new commercial loans was 6.83%, which is up 20 basis points from the 6.63% average for last quarter. In addition, the first quarter rate for all new loans was 6.89%, up 23 basis points from 6.66% last quarter. In closing, as mentioned earlier, we are pleased with our solid performance in the first quarter. It was a strong quarter for deposit growth and the third consecutive quarter of net interest margin improvement. We will continue to benefit from our solid risk management practices and our strong capital position as we move forward. 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.

Thank you. [Operator Instructions] Our first question today comes from Jeff Rulis with D.A. Davidson. Please go ahead, Jeff.

Thanks, good morning. Maybe a question for Jeff. I would say, congrats on the transition. And look, I already always value your genuine approach. So thanks, and I'm trying to get -- I'll try to get the rest of your team to kidnap you down to Scottsdale in a couple of weeks. But I would say in terms of the -- your perspective from Heritage and its position in the Northwest among independent banks clearly in light of continued M&A. Just interested in your perspective from the runway or that slide on Slide 11 is pretty telling you've done a lot of solid team acquisitions. But maybe I'll step back and just from your perspective, how the bank is positioned?

I would say, Jeff, that our position is pretty good. The way we look at it is we have a plan for 2025 and going into '26 with some very specific goals. And I think it's our desire to keep working towards those goals with the idea that we're going to continue to take advantage of opportunities with teams around the footprint. And if there is potential M&A, we've always said that we're ready for that as well. So there's less banks around us. And in some cases, the smaller banks that maybe we didn't take action on are probably mostly because it wouldn't have done much for us in terms of developing our own organization. But there's some -- there's still some attractive banks in our footprint that we'd love to join forces with at some point. But in the meantime, I think we have a pretty solid balance sheet. And as Bryan said, our pipeline is looking pretty good and our deposits are starting to fall back in line. I feel like we're in a pretty good position and I feel good handling the team, the responsibility going forward. They're all veterans. And I would say, overall, I think we're in a good spot.

Got it. And maybe a question for all, just the team in you spoke that you picked up and maybe kind of what led to that move? And any sort of color on that pickup?

Sure. Jeff, this Bryan. It's a group from a larger regional bank. And they had made the determination that they wanted to make a move and sought us out. And we had some dialogue over a period of time, just assessing the fit of the individuals and the type of customer base to make sure it was a good fit for Heritage. And then, of course, the market as well evaluating Spokane assessing whether there was a spot for Heritage in that market. And after going through that process, the answers were yes, yes and yes, and we went ahead and moved forward. We have three bankers there in Spokane. It's a little smaller team than what we've done in the past, supporting it in part from other teams across the bank. And this ties into Jeff's comments earlier. We've got financial goals we're looking to hit here in 2025. And the smaller size of the team is reflective of us just trying to balance, taking advantage of the opportunity to bring in some great talent, but at the same time, trying to manage the expenses so we can still hit our 2025 numbers.

Great. And maybe one last one. I think Don touched on the buyback or lack thereof in the first quarter, you were active in the fourth quarter and it sounds like you're kind of balancing that decision with the restructuring as well. Anything to comment? Was there anything precluding you in the first quarter from that? Or that was just that's a quarter-by-quarter decision? I thought I'd check in on the buyback.

Yeah, it's a quarter-by-quarter decision. Our stock price was up also in last quarter. So it made it somewhat less attractive. And we kind of took a little bit of a break, I guess, you might say we were pretty active last year. Stock price was up in the 24, 25 range. So it was just a decision to make last quarter to kind of just hold on to some capital and -- but it wouldn't surprise me at these levels if we were back, active sometime this quarter.

Great. Thanks a lot.

Thanks Jeff.

Thank you. Our next question comes from Andrew Terrell with Stephens. Please go ahead, Andrew.

Good morning. This is Jackson Laurent on for Andrew Terrell. If I could just start off on the margin, and I apologize if I missed it, but could you provide the spot cost on total deposits at 3.31 and then the NIM in the month of March, if you could as well?

Sure. The NIM in the month of March was 3.45%. Deposit costs for March was -- cost of interest-bearing deposits was 1.92%, which is pretty much the same for the quarter and the spot rate is actually 1.94%. And a lot of this has to do with just mix that happened kind of maybe towards the end of the quarter that could obviously fluctuate if a lot of funds went into some money market accounts that were -- they added to their money market accounts that were paying higher rates, that's most likely what happened. We're not increasing our rates. So that's going to be -- that will fluctuate, and that's why I mentioned it. I don't think we're going to see non-maturity interesting deposits really fluctuate a whole lot until there's a Fed cut at some point. I will -- I do expect, though, that our cost of CDs will continue to come down due to the new rates being lower than what's on the books and especially on the brokered CD where I think we got $110 million in and about half of that is maturing like this month at a handle just over 5, and we think we can lower that about 100 basis points. So that's kind of why we think we're going to continue to see some overall cost deposits opportunities.

Understood. Appreciate the color.

Yeah, I will say one more thing on the margin. We are continuing to see our loan yields. We expect our loan yields to continue to increase. I know it was down quarter-over-quarter, but that was because of the rate cuts in Q4, and we're kind of getting feeling the full impact of that this quarter. The loan yields actually increased from January to March by 3 basis points. So without rate cuts, the new loans going on at higher rates, what's coming off at lower rates will also continue to help us.

Understood. Thank you. You just answered my next 2 questions. If I could transition over to expenses, you guys have done obviously a great job controlling the expense base recently. And I appreciate the $41 million to $42 million run rate color there. I was just wondering if you guys are expecting any additional costs associated with the Spokane team that weren't included in the 1Q expense number.

The Spokane team was added pretty early in the quarter. And so almost all of it is baked in already. If we add personnel there or add additional space of some kind on the occupancy side, that could add more. We're not expecting any significant increases due to that. Bryan, do you want to add on to that?

Got it, thank you.

I was just going to say they started right at the end of January. So same comment Don made. The majority of the costs are already in the Q1 numbers.

Great. Thank you. That’s all I had. I’ll step back.

Thank you. Our next question comes from David Feaster with Raymond James. Please go ahead, David.

Hey, good morning everyone. [multiple speakers] on for David. So I just had a quick question on the new loan commitments. Those were fairly broad-based and really encouraging to see, especially moving into seasonally stronger quarters. Just wondering where you see the most opportunity for further growth given that the commitments are so broad-based right now?

Yeah. If you look at Page 13 in the investor presentation, it's got the breakout of commercial real estate and C&I and construction and really all of last year with the exception of the fourth quarter, really, it was C&I that was leading it and then it was pretty balanced in Q1. And that's really the mix we're trying to maintain. We've had an oversized emphasis on deposit sales and expanding our calling efforts on deposit-rich clients, which is part of the reason you see the high percentage of C&I last year. Again, the banks always pursued C&I, but just have had a really strong focus on deposits seeking balance sheet growth. So I'm expecting the same type of mix we saw last year between C&I and real estate being the 2 primary categories.

Great. And actually touching on the deposit side, the growth was really robust in the quarter. And I know you mentioned that it was both between new and existing accounts. Have any customers in particular been driving that growth? And where are you seeing most opportunity today on that front?

Well, really, if you look at the growth, a lot of it in the last couple of quarters has come from expansion of existing relationships in addition to new relationships. I think what was really unusual about the first quarter, particularly as you compare it to last year was the composition, as Don mentioned in his comments, really the growth in CDs was really pretty nominal during first quarter of 2025 versus last year. It was over $80 million worth of CD growth, and the deposit growth for Q1 last year was actually a negative $67 million. So first quarter is typically a quarter where deposits would decline really typically through tax payments. And then we would typically seasonally see it stabilize growth through the summer and typically through the end of the year. So we've just had a lot of new accounts added to the bank and then we've also seen expansion of existing account relationships. I think some of that in Q1 was what's going on in the market and perhaps some customers bringing just some cash back to the bank rather than maybe deploying it into the market, those sort of things. But we're pleased with it and looking at the new accounts, I guess to answer that piece of it. Most of the new relationships come from other banks that are going through some sort of disruption in the market. And sometimes that takes two or three years' worth of calling before there's a situation where we really get a shot at it. And we've continued to get some good opportunities through. Fourth quarter last year was a big quarter and some of those continue to fund in Q1, and then Q1 was another strong quarter.

No, that's helpful. Thank you. And I know you mentioned the volatility in the markets. And so I guess the last one for me would be, especially given the economic backdrop, it's really impressive to see credit metrics remaining strong. Just wondering, is there anything you're watching more closely? And has your approach to underwriting or managing credit adapted at all?

Yes, that's a good question. Tony, you want to take that one?

Sure, yeah. No, clearly, we're looking at it closely right now. It's a little too early to see any direct impact from all the changes around tariffs and federal funding and things like that. What we're really focused on is just putting an infrastructure, a structure in place to manage that. We have a team that we've -- a cross departmental team we've put together that's pulling a lot of data from our database, and we're trying to cross reference it with those industries we think would be most impacted and really starting to dig into those larger exposures. It's really going to start with client communication because they're the ones that are going to have the best insight into what's happening with their business models, and that's where we're starting. But it will continue to expand. I'm expecting some impact from it, but it's a little too early to say. And for the most part, it's a wait-and-see attitude, but making sure we react, but we don't overreact right now.

Great. I appreciate the color. I’ll step back. Thanks again, guys.

Thank you. The next question comes from the line of Kelly Motta with KBW. Kelly, please go ahead.

Hey, good afternoon or good morning rather there. Thanks for the question. I'm wondering, given -- it feels like a lot has changed in the past, especially the past month. I'm wondering if it's -- given the greater economic uncertainty, if you're changing how you're viewing the year or if you dialed in your expectations at all in terms of anticipated loan growth and the amplitude type for credit.

Yeah. Thanks, Kelly. Good morning. Looking at the current pipeline, which again was above where we ended the year and above last year. So looking at the second quarter, we're looking at an annualized growth rate estimate of kind of in that 5% to 8% range. So we feel like we have good visibility near term. In general, the kind of loan activity and pipeline levels, loan activity, I mean, our banker activity levels and the loan pipeline are stronger coming into this year than they were last year. And last year was an excellent year for loan growth. We did have a decline in the quarter. And if you look at Page 16 in the investor presentation, it gives you a good sense of what was driving that. The originated loans, the outstanding balances were quite a bit lower again just due to the mix of loans. There was a number of construction loans and other unfunded loans in the volume for the quarter. And then in the prepayments and payoffs, you can see that was $127 million for the first quarter, which is significantly above the run rate for last year. And then the other big one is the net advances in payments. That was actually a negative number. And we did have a lot of construction loans that fully funded out last year. This is in 2024 from commitments booked in the prior year. So we went into the year expecting a bit of a headwind related to construction loans paying off, which is obviously what we want to have happen. But at the same time, a stronger pipeline than we had last year. And again, last year was an excellent year of loan growth. So I think the backdrop coming into the year is stronger than it was last year. But the uncertainty is really hard to gauge, how is that going to impact Q3 and Q4 production. And as Tony alluded to in his comments, it's just a little early for us to be able to tell. We are watching both the credit side and the pipeline really closely, lots of interaction with the clients, but just too soon to read. So again, Q2, we're looking at kind of annualized growth in the 5% to 8% range. The pipeline is there. And typically, production would build into the second, third and fourth quarter, but hard to tell at this point, Kelly, exactly how much of the pipeline falls out if this uncertainty continues.

Got it. That's really helpful. And I appreciate all the commentary and color on the new team in Spokane added this quarter. It sounds like it's a smaller team than normal. I'm wondering if -- which areas you may be looking to add density within your current footprint or fill out as you -- there's some additional disruption out west. So I'm wondering where geographically you might see opportunities for Heritage to add talent? Thank you.

Yeah. We're really open to adding talent anywhere within the footprint if we have the opportunity to hire really high-quality bankers. So most likely, it would be kind of a onesie, twosie higher, most likely a replacement for another position that vacated either in that market or another market where we would then move the FTE to a different market if we were able to find a highly talented banker. And then yes, Spokane is a smaller -- a little bit smaller group, but a lot of that is on the support side. The production team is a little bit smaller than what we would, I'll say, started with in the past few teams. But again, that's really us trying to take advantage of the opportunity to bring on the talent, but still with a really tight focus on expenses and hitting our 2025 targets. So I think we're doing a good job of balancing those two items. Of course, the talent availability is not something we can predict or necessarily dictate. But that's just how we're managing kind of the expense side versus the opportunity. Just maybe a little smaller groups than what we might do in a different environment where our margin was a little stronger than it is now.

Got it. Thank you so much. I’ll step back.

Thanks, Kelly.

Thank you. Our next question comes from Adam Butler with Piper Sandler. Please go ahead, Adam.

Hey, everyone. This is Adam on for Matthew Clark. Hope you’re doing well.

Good morning, Adam.

Good morning. Just my first question just is around the loan growth side of things. I know that you commented that 2Q annualized growth is looking and trending towards the 5% to 8% range. But -- and you also touched on the degree of payoff and paydown activity that kind of inhibited growth this past quarter. I know it's hard to predict, but I was just curious if I could get some commentary on how those payoff and paydown trends are going thus far this quarter? And how you think that could -- I guess, the degree you think it could inhibit growth based on your pipeline?

Yeah. In the second quarter, we've incorporated what our expectations are for payoffs in that annualized 5% to 8% range. And since it's relatively near term, looking at the pipeline and payoffs, we feel like that's a pretty reasonable number. Of course, the payoffs could be higher or deals could move a little a month here or there, and that may impact the final number. In Q1 really, the difference was a few business sales that we weren't expecting. So we did have some construction loan payoffs, but we also had a couple of customers that sold businesses and paid off loans. We had another circumstance where a customer had a loan reprice from kind of in the mid-3 range up into the high 6s, and they just opted to pay it off with cash. So that was not, obviously, not expected either. And then as we get into Q3 and Q4, we are expecting more construction loan payoffs there. But again, looking at the pipeline and where it is and where it would typically go and where our production would typically go in Q3 and Q4 should be enough to offset that and come back to that kind of mid-single-digit to high single-digit overall growth. Of course, the unknown is how much the market uncertainty is going to draw back from what we would traditionally do in those quarters. And it was just a little early for us to be able to gauge what that is, although we're watching the pipeline very closely.

Okay. That makes sense to me. And I appreciate that it is baked into the growth outlook or the net growth outlook. And then just the second one for me. It was good to see another securities restructuring this quarter. I was just curious what the timing of the sale was and just your updated expectations and appetite to continue doing similarly sized transactions?

The restructuring actually occurred in March. So we didn't see a full impact of it as far as on the yield side of things for the quarter. But we'll continue to look at that. Again, we kind of make these decisions on a quarter-by-quarter basis. Last couple of quarters, we've basically been somewhat similar on the amount. There's a chance we could up that some. But right now, we do kind of -- want to continue to optimize our balance sheet as best we can, and this is a lever that we can use. So I would expect to continue to have it at some level.

Okay, that’s helpful commentary. And that’s all for me. Thanks for your time.

Thanks, Adam.

At this time, we have no further questions. And so I hand the call back over to Bryan for closing remarks.

Thank you, Emily. 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. We look forward to talking to many of you in the coming weeks. Goodbye.

Thank you, everyone, for joining us today. The replay of this call will be available until Thursday, May 1, and can be accessed dialing the U.S. number, 929-458-6194 with the access code 606836. Thank you for your participation. You may now disconnect your lines.