Heritage Financial Corporation (HFWA) Q2 2025 Earnings Report, Transcript and Summary

Hello, everyone, and a warm welcome to the Heritage Financial 2025 Q2 Earnings Call. My name is Emily, and I'll be coordinating your call today. [Operator Instructions] I would now like to hand the call over to our host, Bryan McDonald, President, to begin. Please go ahead.

Thank you, Emily. Welcome, and good morning to everyone who called in or 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 second quarter earnings release went out this morning premarket, and hopefully, you have had an opportunity to review it prior to the call. We have also posted an updated second 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. Improving net interest margin and tight controls on noninterest expense growth continued to incrementally drive earnings higher in the second quarter. On an adjusted basis, earnings per share were up 8.2% versus last quarter and up 17.8% versus the second quarter of 2024. We are optimistic these trends will continue, and combined with prudent risk management, will provide progressively higher profitability as we finish out 2025. We will now move to Don, who will take a few minutes to cover our financial results.

Thank you, Bryan. I will be reviewing some of the main drivers of our performance for Q2. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the first quarter of 2025. Starting with the balance sheet. Total loan balances increased $10 million in Q2 as loan originations increased from Q1, but payoffs and prepayments remain elevated. Yields on loan portfolio were 5.50%, which is 5 basis points higher than Q1. This was due primarily to new loans being originated at higher rates and adjustable rate loans repricing higher. Bryan McDonald will have an update on loan production and yields in a few minutes. Total deposits decreased $60.9 million in Q2 due to the seasonal decline that occurred in April related to tax payments. However, average total deposits increased $35.4 million from the prior quarter. This marks the fifth consecutive quarter of us showing an increase in average total deposit balances. The cost of interest-bearing deposits increased to 1.94% from 1.92% in the prior quarter. Although we may see decreases in costs in certain deposit categories such as CDs, we don't expect overall decreases in the cost of interest-bearing deposits absent further rate cuts by the Fed. Investment balances decreased $67.6 million, partially due to a loss trade executed during the quarter. A pretax loss of $6.9 million was recognized on the sale of $91.6 million of securities. These sales were part of a strategic repositioning of our balance sheet. A portion of the proceeds was reinvested in $56.4 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 increased $1.3 million or 2.4% from the prior quarter due to a combination of a higher net interest margin and more days in Q2 compared to the prior quarter. The net interest margin increased to 3.51% from 3.44% in the prior quarter due primarily to increases in loan and investment portfolio yields. We recognized a provision for credit losses in the amount of $956,000 during the quarter due partially to loan growth and partially to net charge-offs. Tony will have additional information on credit quality metrics in a few moments. Noninterest expense decreased $298,000 from the prior quarter due mostly to lower benefit costs and payroll taxes as well as lower data processing vendor costs. These decreases were partially offset by higher professional services expense, which is partially related to achieving the lower vendor costs. We continue to guide in the $41 million to $42 million range for quarterly noninterest 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 9.4%, up from 9.3% in the prior quarter. Our strong capital ratios allow us to be active in loss trades on investments and stock buybacks. During Q2, we repurchased 193,700 shares at a total cost of $4.5 million under our current share repurchase plan. We still have -- sorry, 797,000 shares available for repurchase under the current repurchase plan as of the end of Q2. I will now pass the call to Tony, who will have an update on our credit quality.

Thank you, Don. While we saw some modest deterioration during the quarter, the credit quality of our loan portfolio remains strong. Nonaccrual loans totaled just under $9.9 million at quarter end, and we do not hold any OREO. This represents 0.21% of total loans and compares to 0.09% at the end of the first quarter and 0.08% at the end of 2024. The largest addition during the quarter was a $6 million multifamily construction loan. That project is nearly complete and is expected to begin leasing units in the third quarter. There is currently no loss expected on this loan and the nonaccrual decision was primarily tied to the delinquency status. Also contributing to the increase was a C&I loan that totaled $1.7 million when moved to nonaccrual status. During the quarter, we charged this loan down to $1.3 million that is covered by the SBA guarantee. Including this loan, we have just over $2.3 million in government guarantees tied to this nonaccrual loan portfolio. Page 18 of the investor presentation shows the low level of nonaccrual loans we have experienced over the past 3-plus years. Nonperforming loans increased from 0.09% of total loans at the end of the first quarter to the current level of 0.39%. In addition to the previously mentioned increase to nonaccrual loans, we have 3 loans totaling $8.6 million that are over 90 days past due and remain on accrual status. These loans are well secured and in the process of collection. While they are past their maturity date, they continue to make their monthly interest payments. All are expected to be either extended or paid in full during the third quarter. Criticized loans are those [ rated ] special mention and substandard totaled just under $214 million at quarter end, increasing by $35.8 million during the quarter. Most of this increase was in the substandard category with several larger loan relationships downgraded from special mention during the quarter. The biggest driver of the increase is a $14.7 million, nonowner-occupied CRE loan that is current, however, is currently not generating adequate cash flow to service debt. Also contributing to the increase was the downgrade of 2 related owner-occupied CRE loans, where the owner occupant is experiencing cash flow difficulties. At 2.1% of total loans, substandard loans remain at a manageable level and in line with our longer- term historical performance. During the quarter, we experienced total charge-offs of $558,000 that were largely tied to our commercial portfolio. The losses were offset by $64,000 in recoveries, leading to net charge-offs of $494,000 for the quarter. For the first 6 months of this year, we have had $793,000 in net charge-offs. 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. Page 21 of the investor presentation shows our history of low credit losses and how it compares favorably to our peer group. While we have some concern with the increase in nonperforming and substandard loans this quarter, we believe it reflects a continued return to a more normalized credit environment after a period of unprecedented credit quality for the bank. We will continue to closely watch for areas of stress in the economy that could impact our credit quality. We remain consistent in our disciplined approach to credit underwriting and believe this is reflected in the solid level of credit performance we have maintained over a wide range of business cycles. 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 second quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $248 million in new loan commitments, up from $183 million last quarter and up from $218 million closed in the second quarter of 2024. Please refer to Page 13 in the investor presentation for additional detail on new originated loans over the past 5 quarters. The commercial loan pipeline ended the second quarter at $473 million, up from $460 million last quarter and down modestly from $480 million at the end of the second quarter of 2024. During the quarter, we continue to see tariffs and other uncertainty causing some of our customers to suspend capital plans. This is reflected in a pipeline that is relatively flat quarter-over-quarter versus showing a seasonal increase, which is what we saw last year and would be more typical. That being said, we are estimating third quarter commercial team new loan commitments of $300 million or 20% higher than the second quarter. Loan balances were up $10 million in the quarter after a decline of $37 million in the first quarter. Although production was up $65 million versus last quarter, we continue to see elevated payoffs and prepaids. And similar to last quarter, the mix of loans closed during the quarter resulting in lower outstanding balances. Looking year-over-year, prepayments and payoffs are $59 million higher than last year and net advances on loans have swung from a positive $106 million last year to a negative $26 million year-to-date in 2025. Please see Slides 14 and 16 of the investor presentation for further detail on the change in loans during the quarter. Looking ahead to the third quarter, we expect loan balances to be relatively flat due to construction loan paydowns and payoffs increasing further. After the third quarter, we expect loan growth to resume as construction loan payoff activity returns to a normalized level. Deposits decreased during the quarter, but are up $100 million year-to-date versus a decline of $82 million for the same period last year. A decline in deposits similar to what we saw in 2024 is more typical of seasonal flows. The deposit pipeline ended the quarter at $132 million compared to $165 million in the first quarter, and average balances on new deposit accounts opened during the quarter are estimated at $72 million compared with $54 million in the first quarter. Moving to interest rates. Our average second quarter interest rate for new commercial loans was 6.55%, which is down 28 basis points from the 6.83% average for last quarter. In addition, the second quarter rate for all new loans was 6.58%, down 31 basis points from 6.89% last quarter. These average rates are based on outstanding loan balances. The drop in average rates is due to the funding mix of new loans during the quarter and to a lesser extent, the 16 basis point decline in the 5-year Federal Home Loan Bank Index during the quarter. Using commitment amounts versus outstanding balances for all new loans closed during the quarter, the average rate was 6.80% versus 6.86% on commitment balances for the first quarter or a decline of only 6 basis points. In closing, as mentioned earlier, we are pleased with our solid performance in the second quarter. Yields on loans and investment securities continue to increase, driving earnings higher versus the first quarter and the same quarter last year. 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 the various opportunities to continue to grow the bank. With that said, Emily, we can now open the line for questions from call attendees.

[Operator Instructions] Our first question comes from Jeff Rulis with D.A. Davidson.

Don, on the loss trade, do you have a projected earn-back on that as kind of the timing? And then what the expected near-term margin impact would be or benefit?

Well, we have it actually on page we happen to see on Page 6 of our investor presentation, we have kind of that information for Q2. It's approximately a 3-year earn-back on the Q2 activity. In total, we've been doing about 2 years in total, but it was a little longer in Q2. But the pickup is estimated about -- I think about $15 -- $0.05, I'm sorry. So -- or $2.3 million pretax. So I don't have the exact yield pickup for you, but you can -- I guess you can figure that out with those numbers.

Okay. And I guess, Don, we've talked in the past about sort of this maybe winding down on the risk structures, but maybe just checking back in the second half of the year, do you foresee much more of this activity?

As it always is for every quarter, it will depend on 2 things: what the market is going to give us and our needs for capital. You'll notice that some quarters are higher than others. We've always done a little something every quarter. We're always looking to improve the -- even though I think our investment portfolio has performed probably higher than peers in general, we're always looking for ways to improve the overall performance. So I think that you might see something done, but it will all depend. It could be very small to something we've done in the past, but probably not outside the range of what we've been doing over the last few quarters.

Got it. You mentioned the capital impact and maybe for Bryan, I wanted to just check in on other forms of use on the buyback and if there's anything other strategic use of capital that considering or conversations on that front.

Yes. Maybe just -- I'll let Don take the buyback, and then I'll pick up the other component of that.

Sure. I think our stock price was advantageous in Q2. As you noticed, we didn't -- I don't think we did any Q1. So again, that can fluctuate depending on our stock price and other needs. Also in Q1, we were monitoring some concentrations on our nonowner- occupied CRE loans. So again, I -- I'm hesitant to give you any definite guidance on what we're going to do in Q3, but we do have some left over some [ leftover ] -- and still in our repurchase plan, and a lot will depend on the circumstances during the quarter.

And just picking up, Jeff, on the other uses from an organic standpoint, our loan production has actually really been strong. We had a couple of hundred million in Q1, $267 million in Q2. Now these are for the total bank. The numbers I mentioned in the script were just for commercial. And then we're projecting something over $300 million for next quarter. The mix hasn't had as much in the way of funding percentages as what we had last year, but the big change is payoffs and in particular, just a cycling of our construction portfolio. We had net advances last year that were really pretty significant in that category, and we're just seeing those cycle through. So a long way of saying, at least as it relates to Q3, we're not expecting to need a lot of capital to support an oversized level of loan growth related to M&A and what's going on in the market. We're continuing to do what we've done in the past, remaining active and having conversations to the extent they're available just to stay in touch with other banks in the market. And I think as you know, in the Northwest, it's been predominantly credit unions that have been the acquirer here over the last couple of years. But on that front, we certainly remain active in having the conversations. And if there was the right opportunity that we thought was the right fit, we would pursue it. Same message, no change from the past there.

Got it. Sorry, one more, maybe, Tony. I just wanted to kind of get a sense on the credit side. Is there kind of the moves in the quarter? Is that downgrades, does that reflect any added aggressiveness on your part or credit -- refreshed credit review? Or is that more a sign of just individual credits popping up and/or kind of normalization type activity? Just kind of from your end or macro is kind of the question.

Yes. Thanks, Jeff. Yes, I'd say it's really -- it was just identified problem credits that have just been migrating down. And it was just kind of happenstance that it was in the second quarter, we had a couple of 2 or 3 larger deals that had moved down the risk rating curve. So I don't really think it's a real trend at this point. And as I mentioned in my comments, I think it's just more of the normalization that we've been seeing over the past few quarters on our classified and criticized credits. Again, it just don't happen this quarter. It wasn't anything really more aggressive on our part. It was just circumstances.

Our next question comes from Matthew Clark with Piper Sandler.

This is Adam Kroll on for Matthew Clark. So maybe to start, you have really strong growth in commitments and originations during the quarter. So I was just curious on where you see the largest opportunities for loan growth. And also, you mentioned some pause among borrowers given the uncertainty on tariffs, but I would be curious on how that sentiment compares to April?

Sure. And I -- just in terms of the mix of loans that we're seeing, Slide 13 in the investor presentation at the bottom has the breakout between the categories. And it's really CRE more so in the second quarter and first quarter was pretty flat between the different categories as we kind of finish out the year, see a little bit more commercial volume in the pipeline and owner-occupied, although some CRE in there as well. So maybe a little bit more balancing similar to the first quarter, although higher levels. And that's really pretty typical. We're marketing for C&I and owner-occupied and then also doing some nonowner business at the same time. And what was the second part of your question?

Just maybe how the sentiment among your borrowers has changed? I know you mentioned some pause with uncertainty on tariffs, but just maybe how that changed over the quarter.

Yes. It's -- we're seeing, as I mentioned, the pipeline is -- remains strong. I think had it not been for the level of uncertainty in the market, we would see the pipeline up above where it is now. So I guess the good news is we grew the pipeline quarter-over-quarter. We're down a little bit versus last year, but not much. We're at $473 million versus $480 million. I would guess we'd be at just for kind of reference, $520 million, $530 million, $550 million, if it wasn't for kind of the tariff activity. So that gives you a sense maybe the pipeline is off somewhere around 5% to 10% of where it would be otherwise. And out in the offices visiting with the bankers, things are just moving a little slower in some of the offices with the customers. And then in other cases, we've got bankers with a more full pipeline. So this is a little bit more intermittent than I think what we would see had we not had the disruption and some level of continued disruption in the market.

Got it. I appreciate the color there. Maybe just switching to the margin. I was wondering if you had the spot rate on deposits at June 30 and maybe in NIM for the month of June?

Sure. The spot rate was 1.92% for -- as of June 30. And I believe our NIM was 3.58%. So you can see that it continues to increase. Again, June is pretty -- so it's always a little higher on 30-day month compared to 31, just to be full disclosure there, but still seeing an upward growth on the NIM.

Right. And then if I could squeeze in one more. I was just curious on the timing of when the investment securities sale and reinvestment occurred during the quarter?

Most occurred in June.

Our next question comes from Kelly Motta with KBW.

This is Charlie on for Kelly. I've had most of mine answered, but circling back to growth quickly, you've added some new teams recently. So I'm just wondering any update on kind of the ramp up there with production. And if you think those relationships have been brought over if those teams are fully up to speed. And then a second part to that, if there's potential for further team lift outs if you're still looking for those?

Sure. We expanded our -- the last 2, we expanded our construction team. This is 1 to 4 real estate construction last -- this summer of '24. And that team was fully staffed here at the beginning of this year. And our overall goal was to grow balances in that segment by about $75 million. Everything is going as planned, and we're pleased with the results. Maybe we'll lag a little bit versus what we were originally expecting, but that has more to do with some of the customer base slowing on some of their starts here earlier this summer, but expect that one to come in close. The other one was Spokane, which we announced in January. And based on the closings and it's a loan production office right now, will be a full-service branch as we identify new space and make application. But really pleased with the results so far, based on the loan closings and the commitments and what's in the pipeline, we already have a line of sight to the team hitting their year-end targets that we've set for them. So both are going well. And that kind of dovetails into your next question, which is new team lift-outs. With Spokane being on target, we'd certainly be open to doing additional lift-outs. We've been a little bit more limited last year and the year before, just trying to get our profitability back up. And so it's a balancing act. But we would certainly be open to considering new teams and are always out in the market talking. It's just a matter of having -- making sure we have the right fit and feel like there's an avenue for us to hit the numbers.

Awesome. And I guess just rounding up the margin conversation, I apologize if you already hit on this, but what do you kind of expect going forward with loan yields? Do you see those continuing to kind of like drift up ex rate cuts?

Yes, the question -- go ahead, Don.

Yes, we do due to the repricing of just for rate loans in addition to any new loans going on at higher rates. So even with no rate cuts, we expect the 5-year [indiscernible] has remained fairly stable. So that's where we price a lot of our real estate loans off of. And of course, the prime rates haven't dropped. So what is repricing is going up higher.

And Charlie, I'd just add to that. If you look at Page 28 of the investor presentation, it has the repricing detail that Don just went through. So our average portfolio loan rate is 5.5%, and you can see the repricing rates and the rates of the matured loans. And then the new rate on commitments during the second quarter was 6.8% again versus the 5.5% average portfolio rate. So there is upward movement as we book new loans and get repricing.

Our next question comes from Liam Coohill with Raymond James.

This is Liam on for David Feaster. Just actually following up on Charlie's question. It's [indiscernible] to see loan yields hold up so well while also originating increased volume in 2Q and looking at good growth moving forward. [indiscernible] the competitive environment in your markets? And are you seeing any competitors potentially trying to fight on price to get deals done?

Yes, Liam, it's a good question. So the short answer is yes. I think the overall volume available in the market has gone down somewhat. And then, of course, that increases the competitive circumstances. So it's always in play for the categories that we go after. But with a little bit of volume decline, we're certainly seeing that. In terms of the impact, our overall pipeline is holding up well. So we're still able -- have still been able to find deals to replace that we've closed. And then I would just -- last thing I would say is the new teams that we've added in the last couple of years, that's kind of incremental volume, if you will, over what we would be doing otherwise. So that's also contributing to the increased pipeline. If we didn't have the new teams, you would see more of a dip in the pipeline versus what we're referencing. So hopefully, that back story helps.

No, I appreciate it. And also touching on one of Adam's questions, mentioned expanding the loan office in Spokane to a full branch. Curious to hear what some of the -- that deposit growth potential in that market might be? Like what end customers do you think might be strong depositors in that branch?

Yes. Good question. It's really more about the timing we've always planned to open a full-service branch. And in the majority of the new expansion markets we've gone into, we're in an upper floor office space, but want to have full deposit-taking capabilities to be able to bank the full relationships from the business clients that we bring in. So this is really just a matter of time. We moved into some temporary space and wanted to identify permanent space before staffing for a full branch. So again, always planned, just not at that stage. In terms of the potential deposits, the relationships that we're bringing in, we would expect full deposit relationships. Right now, we're a loan production office. So we're somewhat limited, but kind of normal compensating balances, nothing particularly unique about Spokane really driven off our ability to attract new clients.

And just last one for me. I know earlier you mentioned certain offices have been seeing more strength than others on the loan production side. And just curious to hear what dynamics have been driving that? Is it more stronger geographies in particular areas, different end market focuses? Or has it been some of those new teams that have brought additional strength?

There's no specific pattern. The economy is actually really strong throughout the corridor on the west side of Washington up and down the I-5 corridor all the way, South Eugene, it's strong. So it's just more intermittent what the customers of a particular office are doing or not doing. And then the only other couple of comments I'd make, our strongest markets are the King County MSA and then the Portland MSA, which King County MSA encompasses the counties to the north and the south, but those are -- that's because those are the largest markets. They tend to make up the biggest portion of our pipeline. And then the other big driver is just where is the most disruption in the market because we tend to get our new accounts where we have a disruptive marketplace where there's been M&A activity or other changes at other institutions that might cause customers a little bit of a push away to consider coming to Heritage, particularly if we have somebody that's worked with them previously at a prior bank. So maybe a little bit heavily -- a little bit more heavily weighted to some of the new teams. But at the same time, they don't have a portfolio, so they are out in the market, fully calling with all their time. So anyway, hopefully, that helps.

At this time, we have no further questions. And I'll turn the call back over to Bryan McDonald for closing remarks.

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