Heritage Financial Corporation (HFWA) Q4 2025 Earnings Report, Transcript and Summary

Hello, everyone, and welcome to the Heritage Financial 2025 Q4 Earnings Call. My name is Emily, and I'll be coordinating your call today. [Operator Instructions] I would now like to turn the call over to Bryan McDonald, President and CEO, to begin. Please go ahead.

Thank you, Emily. Welcome, and good morning to everyone who called in and those who may listen later. This is Bryan McDonald, CEO of Heritage Financial. Attending with me are Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer. Our fourth quarter earnings release went out this morning premarket, and hopefully, you've had the opportunity to review it prior to the call. In addition to the earnings release, we also posted an updated fourth quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity and credit quality. We will reference this presentation during the call. As a reminder, during this call, we may make forward-looking statements, which are subject to economic and other factors. Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within the earnings release and the investor presentation. Our improving net interest margin and a shift in our loan mix benefiting the provision expense drove earnings higher in the fourth quarter. On an adjusted basis, diluted earnings per share was up 18% versus last quarter and up 29% versus the fourth quarter of 2024. And on the same adjusted basis, our ROA improved to 1.29% versus 0.99% in the fourth quarter of 2024. We now have regulatory and shareholder approval for the pending merger with Olympic Bancorp and plan to close at the end of January. Their addition to the Heritage franchise will add to the profitability of our operations and better position our company for growth in the Puget Sound market. We will now move to Don, who will take a few minutes to cover our financial results.

Thank you, Bryan. I will be reviewing some of the main drivers of our performance for Q4 as I walk through our financial results, unless otherwise noted, all the prior period comparisons will be with the third quarter of 2025. Starting with the balance sheet. Total loan balances increased $14 million in Q4. Yields on the loan portfolio were 5.54%, which is 1 basis point higher than Q3. The positive impact of new loans being originated at higher rates and adjustable rate loans repricing higher was partially offset by the impact of 3 rate cuts over the last 4 months of the year. Bryan McDonald will have an update on loan production and yields in a few minutes. Total deposits increased to $63 million in Q4. This increase was due primarily to a $100 million increase in interest-bearing demand deposits. The cost of interest-bearing demand deposits decreased to 1.83% from 1.89% in the prior quarter. As a result of rate cuts in Q4, we expect to see continued decreases in the cost of deposits. Investment balances decreased $31 million due primarily to expected principal cash flows on the portfolio. The yield on the investment portfolio decreased 9 basis points to 3.26% for Q4 compared to 3.35% in Q3. This decrease was partially due to a bond called in Q3 that provided approximately 4 basis points of additional accretion income that quarter and partially due to the runoff of higher-yielding bonds without replacement of those balances at current market rates. The cash flows provided by the investment portfolio as well as growth in deposits was used to pay down borrowings during the quarter. Borrowing balances decreased to $20 million at year-end from $138 million at the end of Q3. The remaining balances all mature in 2026. Moving on to the income statement. Net interest income increased $1 million or 1.7% from the prior quarter due primarily to a higher net interest margin. The net interest margin increased to 3.72% from 3.64% in the prior quarter and from 3.36% in the fourth quarter of 2024. We recognized a reversal of provision for credit losses in the amount of $814,000 in Q4. This reversal was due primarily to a change in the mix of the loan portfolio. During Q4, commercial construction loans decreased while permanent commercial real estate loan balances increased. We consider construction loans to have an inherently higher credit risk component and provided a much higher allowance on those loans. Therefore, the reallocation of those balances resulted in the allowance decreased to 1.10% in Q4 from 1.13% in Q3. In addition, net charge-offs remain at very low levels. Tony will have additional information on credit quality metrics in a few moments. Noninterest expense decreased $132,000 from the prior quarter due mostly to lower merger-related expenses. Comp and benefits expense was higher due primarily to increased incentive compensation accrual and not due to additional employees. We continue to manage our employee levels carefully as shown by decreases in average FTE from both the prior quarter and the same quarter in the prior year. And finally, moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds and our TCE ratio was 10.1%, up from 9.8% in the prior quarter. We were inactive in both lost trades on investment and stock buybacks in Q4. I will now pass the call over to Tony, who will have an update on our credit quality.

Thank you, Don. I'm pleased to report that we ended the year with strong credit quality across all segments of our loan portfolio. Nonaccrual loans totaled $21 million at year-end, and we do not hold any OREO. This represents 0.44% of total loans and compares to 0.37% at the end of the third quarter. The increase was primarily attributed to 3 nonowner-occupied CRE loans that were moved to nonaccrual status due to their delinquency. These loans are all well secured and are expected to pay off from either sale or refinance of the underlying properties with no anticipated loss. Total nonaccrual additions of $4.4 million were partially offset by $1.1 million in payoffs or paydowns. Within our nonaccrual loan portfolio, we have just over $2.4 million in government guarantees. Nonperforming loans were stable during the quarter with the 0.44% of total loans matching the ratio at the end of the third quarter. In addition to nonaccrual loans, loans over 90 days and still accruing was limited to one small residential mortgage loan with a balance of $194,000. Criticized loans moved lower during the quarter. However, we did see an increase in our substandard loans. Criticized loans totaled just under $188 million at year-end, declining by $6.6 million during the quarter. While special mention loans were lower by 29%, some were downgraded to substandard, resulting in a 24% increase in that risk category during the quarter. The largest contributor to the increase came from the downgrade of 2 C&I relationships totaling just under $30 million. Partially offsetting the downgrades was the resolution of a long-term problem loan workout for a nonowner-occupied CRE loan, resulting in a full payoff of $15.6 million. While we are closely watching this increase in substandard loans, they remain at manageable levels at 2.44% of total loans and in line with our longer-term historical performance. Page 19 in our investor presentation provides more detail on the composition of our criticized loans and reflects the stability we've seen over the past 2 years. During the quarter, we experienced total charge-offs of $640,000, primarily in our commercial loan portfolio. The losses were partially offset by $159,000 in recoveries, leading to net charge-offs of $481,000 for the quarter. For the full year, total net charge-offs were just under $1.4 million or 0.03% of total loans. This compares favorably to our 2024 performance, where net charge-offs were just over $2.5 million, representing 0.06% of total loans. We are pleased that our early identification and proactive management of problem credit has led to another year of exceptionally low loan losses. The correlation between these credit management practices and our low level of historical loan losses is demonstrated on Page 20 in the investor presentation. Overall, we remain pleased with the credit quality of our loan portfolio at year-end. We believe our consistent and disciplined approach to credit underwriting and concentration management will continue to generate strong credit quality performance in a wide range of economic conditions. I'll now turn the call over to Bryan for an update on our production.

Thanks, Tony. I'm going to provide detail on our fourth quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $254 million in new loan commitments, down from $317 million last quarter and down from $316 million closed in the fourth quarter of 2024. Please refer to Page 13 in the investor presentation for additional detail on new originated loans over the past 5 quarters. The commercial loan pipeline ended the fourth quarter at $468 million, down from $511 million last quarter and up modestly from $452 million at the end of the fourth quarter of 2024. As anticipated, loan balances were fairly flat quarter-over-quarter with a $14 million increase in the quarter. Total new loan production of $271 million was largely offset with elevated payoffs and prepaids. Looking year-over-year, prepayments and payoffs were $208 million higher than the prior year and net advances on loans have swung from a positive $153 million last year to a negative $81 million in 2025. Please see Slides 13 and 16 in the investor presentation for further detail on the change in loans during the quarter. Looking ahead to 2026, we expect to resume loan growth at more historical levels as we are through the period of [ known ] elevated loan payoffs, and we expect net advances to move back to a positive position. Deposits increased $63 million during the quarter and were up $236 million for the year. The deposit pipeline ended the quarter at $108 million compared to $149 million in the third quarter, and average balances on new deposit accounts opened during the quarter are estimated at $43 million compared to $40 million in the third quarter. Moving to interest rates. Our average fourth quarter interest rate for new commercial loans was 6.56%, which is down 11 basis points from the 6.67% average for last quarter. In addition, the fourth quarter rate for all new loans was 6.43%, down 28 basis points from 6.71% last quarter. In closing, as mentioned earlier, we are pleased with our solid performance in the fourth quarter. Our assets continue to reprice upward and deposit growth has allowed us to pay down borrowings. These factors drove our net interest income up $1 million versus last quarter and up $4.6 million versus the fourth quarter of 2024. The combination with Olympic Bancorp and its subsidiary, Kitsap Bank, will add to this positive momentum. We look forward to having the exceptional bankers at Kitsap join the Heritage Bank family and are excited about what we can accomplish together. Overall, we believe we are well positioned to navigate what is ahead and to take advantage of various opportunities to continue to grow the bank. With that said, Emily, we can now open the line for questions from call attendees.

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

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

Yes. Thanks, Jeff. There's -- if we look back and see what happened, we -- this last quarter, we had -- well, we've had about 3 rate cuts in the last 4 months of the year. And we were still able to slightly grow our loan yields in Q4. So this is where the -- in a quarter where we have rate cuts, we're going to have this balancing where we're repricing our adjustable rate loans higher, putting on new loans at higher rates, but the adjustable rate loans or the floating rate loan will be obviously repriced down those tied to [ prime ] or SOFR. So kind of even for this last quarter, if we have quarters where we don't have rate cuts, we expect more improved improvement in the loan yields. And then on the deposit side, the cuts help us speed up, I guess, our deposit betas. But at the same time, I think because we had rate cuts at the end of the year, I think we'll continue to see some improvement in our -- on the cost. So overall, I think that -- and this is all without the merger, right, that's going to occur. So just on the -- on the legacy Heritage side, we expect to see margin improvement to continue over the next year or 2.

Got it. And if I could take that step of incorporating Olympic look like their margin was a little bit lower, but a smaller balance sheet and adding accretion. Any thoughts on the kind of the blended -- if we look at legacy upward trending roll in Olympic, any broad level thoughts on the consolidated margin?

Well, and I'm going to preface this if I get questions about this year as far as the combined because obviously, we have some fair value work to do once the deal closes, and we will get that done in this quarter. And so we've got some initial estimates from that we did in our due diligence. I don't think they've changed a whole lot, but I will just preface that, that it's a little less precise than we would might normally be on this. But there -- I think their loan portfolio will probably reprice with yields up in the low 6s. So if you think about that, and then the deposits are already -- I think they're over 20 basis points lower than our cost of deposits. And then the investment portfolio should reprice probably up into the low to mid-4s, which I think they're at 3 or a little under on there currently. So I think that we're going to get a nice bump in margin where we could potentially get near that 4% range by the end of the year.

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

Yes, Jeff, it would just add to -- yes, so the short answer is yes, but would add to that, looking at the pipeline at the end of the fourth quarter, the $468 million, and we have good visibility near term. So I would say low single digits is our estimate kind of Q1. And then I would move that to upper single digits based on what we're seeing from the customer base and loan demand heading into 2026, which is the pipeline has been increasing since year-end. So that's our thought based on what we're seeing today.

Okay. So a slow rate and then accelerating as we go over the course of the year.

Yes.

Our next question comes from Matthew Clark with Piper Sandler.

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

Yes. So the -- I would say the bulk of the payoffs we were anticipating did come through. The payoffs were -- payoffs and prepaids were a little over $170 million for the quarter, which was the highest quarter of the of the year. And so for the total year, it was more like $540 million, $550 million, around $45 million a month. We think that's going to moderate at least based on our current visibility, potentially 1/3 less. And then as I said in my comments, last year, we had this -- last year being 2025, we had net advances on loans fall $81 million versus 2024, where they were up $153 million. So we've cycled through that. And I think we should also see net advances move up modestly in 2026. So potentially 1/3 less payoff prepay volume and then not the negative drag from net advances that we had in 2025. So that's kind of what's happened in '25, and it has played out substantially based on our expectations as we came into '25.

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

Sure. Don, do you want to take that?

Yes. I think we're combining with -- there's so much, I think, noise going on. I think maybe we'll just maybe just talk about what kind of we're expecting. We are expecting approximately $20 million, $21 million of merger-related expenses. So -- but we're moving those, I think starting in Q2. And the other thing we have going on here is our conversion is not expected to take place until sometime into September. So we're keeping a large amount of the employees that at some point will be gone by the end of the year, but we'll keep them through Q3 because it will be on 2 separate systems. Then we'll have a reduction of employees after that. But probably a run rate for Q2 and Q3 will probably be in the 56s some -- probably somewhere in the 56% range, maybe a little 56%, 57%. So that will be for Q2, Q3, and then we'll have some -- we'll get more of our cost savings in Q4. And the core will probably be down more in the $54 million range after that.

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

Bryan, do you want to take that one or?

Yes, sure. I'll take that one. Let me take the second part of your question first, just in terms of preparedness. We did extensive planning back in 2023 when we were about $7.7 billion in assets, felt like we had 3 or 4 years, but we wanted to be very clear on what we needed to do. So we put together a pretty detailed plan, met with our regulators and a variety of other parties. And so we've been making progress on that plan. Since then, with our deposit outflows we had in 2023, we felt like we had a little bit of additional time. And so anyway, we've been making progress on that and have a good view into what the requirements are. In terms of when we cross the $10 billion, our focus now is on integrating Olympic and making sure that all aspects of that go as planned. On an organic basis, we're several years out from crossing the $10 billion. So that's how we're looking at it right now, executing on the plan to be ready, but still seeing ourselves a ways off from crossing it.

Our next question comes from Jackson Laurent with Stephens.

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

Yes. Sure, Jackson. I'll take that. So on commercial loans, the new loan production went on at 5.56% during the quarter. And then in total, it was 6.43%. So that was down a bit over -- a bit over Q3. Some of that's due to the drop in short-term rates, any variable rate loans we have just kind of naturally are going to come on at lower levels. And then the rest is just driven really off of what the Federal Home Loan Bank, particularly the 5-year index does during the quarter. From just purely a competitive standpoint, it continues to be a really competitive market for the clients that we're going after and particularly so if it's a new relationship to the bank where there's maybe several banks competing for that opportunity, although I would say that's not significantly different than it normally is. So we're not seeing necessarily any outsized competition. It's just always competitive for that -- for the type of clients we're going after.

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

Don, do you want to take that?

Yes. We have -- we're still at about the same level of exception priced, but it's the cost -- overall cost at year-end, I think we're down to about -- I think we're at maybe [ $270 million ] at this point. So -- and we still have -- there's some other -- still other -- we still have about $100 million of floating rate public deposits that would come down if there were rate cuts. We didn't experience all that impact because, again, we had a rate cut in December. So we'll -- that will help out. And of course, the CD rates, I think, keep coming down. So our average rate of CDs -- core CDs is like -- like [ 360 ], I think, we'll keep working those down. I think the current -- our current highest rate is like [ 330 ]. So there's definitely -- we're expecting costs to keep coming down. Our December cost was lower than for the quarter by about 4 basis points. So that's just, again, another sign that it's going to keep coming down a little bit.

Got it. That's helpful. And then just last one for me. I know we talked about like uses of capital being on hold until the closing of the Olympic transaction. But with a clear line of sight to deal close later this month and capital building nicely, I was just wondering if you could kind of update us on capital priorities in 2026?

Sure. Don, do you want to take that?

Sure. Well, again, the first one was just closing the transaction. And that will use about -- again, we've mentioned this before, about 100 basis points of capital. So that's the most important use of capital this year. We will look into other uses as we do more planning and as we get through, again, the fair value, so we really know what our balance sheet looks like, we can take, I guess, more steps to manage it to the levels that we want to be at. So there could be some buybacks. We have about 800,000 shares left in our current repurchase program. There's always a chance we could do more loss trades, but we're not planning any at this point. But there's a chance we could do. I would say we could do buybacks. If we find that the dilution is less, but maybe the accretion is less from the deal, then maybe buybacks make sense to kind of offset that. So we'll kind of -- we're working on that now. Again, after the deal closes at the end of the month, we'll definitely be looking carefully at that.

Our next question comes from Liam Coohill with Raymond James.

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

Yes, Liam, it is. It's really a continuation of what we've been doing throughout the bank's history, just relationship banking, high service quality delivery. And then we added significantly to our deposit sales team over the last several years. And so we continue to see new relationships coming in from the investments we've made with our deposit teams. And Slide 11 in the investor deck has that detail. But back in 2022, we added 3 teams that year and 2/3 of that group were deposit-generating staff. And then, of course, several new locations, both in Oregon and then Boise and then also Spokane. So it is a continuation of what the banks always focused on, which is those relationship clients, but we've benefited pretty significantly from both the new teams as well as our existing efforts in that area.

Great. And just one more for me. On the credit side, I'm just curious if there's any underlying trends or industries that you're watching more closely? And on the couple of C&I downgrades in the quarter, were those idiosyncratic? Or were there any commonalities?

Sure. Tony, you want to take that one?

Yes, sure. Liam, there was really no correlation between those 2 deals. They're in kind of separate industries. And I guess the big question is -- was there any tie-in to tariffs or things like that? And I would say no. So not really anything that I can really point out to. Obviously, both being in C&I category jumps out, but I think it was just -- that was just more timing than anything else and doesn't really reflect anything that we're watching any more closely in the portfolio.

Our next question comes from Kelly Motta with KBW.

I guess as we look ahead, your efficiency ratio for the past couple of years has hovered in that mid-60 percentage range. You did a bunch of things with the securities loss trades and such expense saves in order to kind of mitigate some profitability headwinds. Now with the increased scale from Olympic, wondering how you're thinking about how that helps with generating perhaps better efficiency ahead? Is that a way you're thinking about it? Just interested in thoughts here since it seems like the growth and margin picture is shaping up quite nicely.

Yes. Maybe, Kelly, thanks for the question. I'll have Don start and then maybe I'll provide some comments after Don shares his thoughts.

Okay. Thanks, Bryan. Yes, we're going to -- I think just the overall -- are you talking about the efficiency ratio itself, Kelly? Or are you just talking about operations?

Yes. I was speaking specifically with the efficiency, but I don't know how you necessarily think about it. So if it's easier to talk about it, just is operational efficiency in general, that's okay, too.

Okay. Well, I'll just touch on the -- obviously, we're going to get overall efficiencies between the 2 organizations. Our efficiency ratio will continue to go down over time. But I will say also that I think it will be mostly driven on the revenue side as opposed to the expense side, but we are looking at, again, trying to keep our expense base at a good level. But Bryan, I don't know if you want to talk any more about what you see in the overall efficiencies of the organization.

Yes, I would just add a little bit on to what Don said. If you look at the trajectory of Heritage kind of independent of the combination with Olympic, we've had a big increase in our margin year-over-year. So Q4 last year was 3.36% and 3.72% and Don had mentioned in terms of answering Jeff Rulis' question, we see potential to get that margin potentially up in the 4% range within the not-too-distant future. So that's the revenue driver. Beyond that, the combination with Olympic is bringing a significant amount of low-cost deposits. There's a little bit of a recap on Slide 6 of the investor presentation on the merger with Olympic. And one of the bullet points highlights their cost of deposits at [ 102% ]. It doesn't note their loan-to-deposit ratio, but it's in the mid-60s and ours, of course, is just over 80%. So there's potential significant potential upside. It just some moderate additional leveraging in the loans over the next few years that will give us room to drive that efficiency ratio lower. So those are my thoughts. Obviously, we'll be continuing to focus on ways that we can continue to scale the company without adding significant cost. We'll be continuing to focus on our expense run rates. But if you look at kind of what's happening on the loan repricing side and the asset repricing, the addition of the Kitsap balance sheet mark-to-market on the asset side, it's a pretty good outlook. And then, of course, if you add the additional leveraging, there's a lot of additional potential beyond that.

Got it. Maybe last question for me. I realize this is a little early to be asking this question. But with Olympic on board, I'm just wondering if there's been any updated M&A conversations knowing that you've been more recently active here?

Sure. We're really focused on making sure that we get the combination with Olympic successfully integrated, and that's definitely our -- in our #1 priority here in 2026. We -- at the same time, we have continued to be active in conversations just as we always do so that if another bank within our footprint makes the decision that they want to partner with somebody that we're a known party to them and hope to be considered if that was the case. So really no change from our past conversations. We're continuing to have them. The only nuance, which I' just added is we're very focused on making sure that we get Kitsap integrated over additional M&A.

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

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

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