Q4 2020 Heritage Financial Corp Earnings Call
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Ladies and gentlemen, thank you for standing by welcome to the Heritage Financial Earnings Conference call.
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I'll now turn the conference call over to your host President and CEO, Jeff Deuel. Please go ahead.
Thank you Alan.
Welcome to all who called in and those who May listen later this is Jeff Deuel CEO of heritage.
Attending with me are Don Hinson, our Chief Financial Officer, Brian Macdonald, our Chief operating officer.
Tony Shop had our chief credit Officer.
Our earnings release went out this morning pre market and hopefully you have had the opportunity to review it prior to this call. We have also posted an updated fourth quarter investor presentation on our Investor relations for them.
One of our web site.
Please refer to the forward looking statements from the press release.
We are pleased with our performance in the fourth quarter. We continue to operate the bank effectively with the majority of our branch lobbies open by appointment only and about 40% of our workforce still working remotely.
Despite the challenging circumstances, we've adapted and this operating model is working for us and actually has helped us identify new areas for efficiencies and increased productivity.
We have reached a plateau something of a plateau with regard to the reopening of the economy and the two states, where we operate a major metro areas are still generally operating in a more limited fashion.
That would be downtown Seattle downtown Portland.
But there is more normal activity when you get outside the core metro areas, which is where heritage has a pretty significant presence.
We expect the region will reign remain at the current levels of activity until we see more relief from the vaccines, which is coming out slowly.
In the fourth quarter, we announced the consolidation and closure of nine branches or 15% of our branch footprint.
One branch closed in October and eight branch locations closed in mid January.
We did this to continue improving operating efficiency.
And it is in line with the changes happening in the banking industry overall.
For the nine locations five were owned real estate.
All of which was sold prior to year end and two are already under contract to be sold.
You will also have noticed the gain on sale from our property sold in the fourth quarter, which was a property that formerly how's the branch in some of our back office operations.
We accept expect.
We expect to see incremental benefits and efficiencies beginning in Q1 2021.
We continue to focus on digital enhancements to improve customer experience.
And improve the efficiency of our back office operations.
Our focus started with the new Treasury management platform, we call heritage direct which was implemented in phases, starting in the spring of 2020.
We continue to focus on development and implementation of our commercial loan origination and automated commercial loan origination system and automating customer relationship management platform.
It will allow us to do more with the same workforce.
And also provide a better experience for our customers.
We expect to realize benefits from these initiatives over the next few years and borrowing a phrase from the aviation industry, which has a long history in the Pacific Northwest, we are moving away from visual navigation to navigation through instrumentation.
Well now move on to Don Hinson, who will take a few minutes to cover our financial results, including some color on our core operating metrics.
Thank you Jeff.
As reported in our earnings release, we recognized earnings of 66 per share in Q4 compared to <unk> 46 cents in Q3.
We also reported a $3 3 million.
Or a 15% increase in our pretax pre provision income from the prior quarter.
For digging further into the income statement I'm going to start by reviewing the balance sheet.
Starting with loans, our loans receivable decreased $198 million from Q3.
This decrease was due mostly to a 153 million dollar decrease in SBA PPP loans as a result of the forgiveness process.
In addition, we had decreases of $32 million and consumer loans and $17 million and C&I loans.
The decrease in C&I loans balances.
Due mostly to a decrease of $13 million in two large relationships.
Consumer loan balances are decreasing primarily.
Due to indirect auto loans, which we ceased originating early in 2020.
Indirect auto loans decreased $27 million in Q4, and we expect that will approximate.
The run off in future quarters.
Brian Macdonald will discuss loan production in a few minutes.
Deposits decreased $91 million in Q4, due primarily to a decrease of $96 million and one public deposit relationship.
This wasn't an investment account for the public entity as opposed to an operating account and we decided not to pay the higher rate due to our significant liquidity position.
Moving out of the allowance for credit losses in Q4, we recognized a reversal of provision for credit losses in the amount of $3 1 million compared to a provision of $2 7 million in Q3, which favorably impacted pretax income by $5 9 million quarter over quarter.
The total reversal of provision for Q4 included a reversal of provision for unfunded commitments in the amount of 341000.
At the end of Q for the allowance for credit losses on loans was 157%, which is unchanged for the percentage at the end of Q3.
Excluding PPP loans, which are guaranteed enough provided for the allowance for credit losses on loans was 187% at December 31, a decrease from $1, 93% at September 30.
This lower allowance percentage was due to a decrease in allowances on individually evaluated loans as well as slight improvements in the economic forecasts from from the prior quarter.
Due to various factors, including government stimulus programs.
Charge offs in 2020.
Have been lower than we originally thought they would be at the end of the at the beginning of the pandemic.
Net charge offs for 2020.
We're only seven basis points.
The magnitude of future provisions will be dependent on a combination of factors, including economic forecast.
Charge off experience net loan growth.
Tony shelf and will discuss credit quality metrics in a few minutes.
Our net interest margin increased 15 basis points in Q4. This occurred mostly due to the 21 basis point impact of PPP loan forgiveness for the deferred fees were accelerated at the time of forgiveness.
The impact of PPP for given this was partially offset by lower yields on the investment portfolio and our loan portfolio ex PPP as.
As well as a higher percentage of lower yielding overnight cash balances.
Partially offsetting the lower asset yields was a decrease in the cost of deposits.
Deposit cost decreased in all categories with a total cost of deposits decreasing to 14 basis points in queue for a reduction of five basis points from Q3 levels.
Noninterest income increased $3 $3 $1 million from the prior quarter due mostly to a combination of various items, including a death benefit of fully policies net gains from the sale of branch buildings.
Fees realized from the sale of our trust operations and increases in gains on sale of mortgage loans.
Noninterest expense increased $2 5 million from the prior quarter due mostly to $1 4 million of costs recognized in Q4 in association with the branch consolidation plan that Jeff previously mentioned.
In addition to severance costs recognized for branch consolidation.
Compensation expense also increased due to increases in estimated incentive payouts as a result of improved performance metrics.
We expect to continue to see elevated expense levels in both compensation and professional services as a result of efforts surrounding PPP loan forgiveness, and a new round of PPP loans.
I wanted to briefly discuss our effective tax rate.
2020 was the last year, we were able to utilize a seven year new market tax credit.
The amount of the tax credit for 2020 was $1 $5 million.
Although we continue to seek to add other tax credits, we do expect our effective tax rate to increase.
2021, as a result for the exploration of the current new market tax credit.
And finally, moving on to capital all of our regulatory capital ratios increased from the prior quarter and are strongly above well capitalized classification thresholds.
Our TCE ratio was eight 9% at December 31, and is 10% when you remove the impact of the PPP loans.
Based on our strong capital position and improved outlook on the future.
We are lifting our self imposed suspension of our stock repurchase program.
I will now pass the call to Tony shelf, who will have an update on credit quality metrics.
Thank you Don regarding credit quality, our net charge offs for the fourth quarter were $363000. This was primarily attributed to the partial charge off of a commercial construction loan that was impacted by cost overruns and construction delays.
Net charge offs for the year totaled $3 $2 million, which was very similar to what we experienced in 2019.
We also experienced increase in non accrual and potential problem loans due to the continuing impacts of COVID-19 non.
Non accrual loans increased by $5 $5 million during the fourth quarter and ended the year at one 3% of loans receivable.
The increase in non accrual loans was primarily the result of two commercial and industrial relationships and to owner occupied commercial real estate loans net of all had some impact from the COVID-19 pandemic.
Potential problem loans increased by $45 $2 million during the fourth quarter or 28, 3%.
The majority of this increase was from loans impacted by COVID-19 related issues that continued to demonstrate weakness.
Almost all of these additions were downgraded to special mention with only a small portion downgraded to sub standard.
Regarding loan modifications under the cares act and related regulations in 2020, the bank provided loan modifications on 2041 loans with total balances of approximately $667 million using March 31st numbers for borrowers that were impacted by COVID-19 related issue.
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As of December 31, there were 175 loans totaling approximately $70 million that remained in a payment modification status.
Using outstanding loan balances. The majority of these borrowers were making interest only payments versus a full deferral of their loan payments.
Of these remaining borrowers, 35% or approximately $25 million or in the hotel and restaurant categories. The industry's most impacted by COVID-19.
In summary, approximately 88 per cent of the borrowers that received a payment deferral COVID-19 modification in 2020, we're no longer in a COVID-19 status a modification status as of December 31.
And of the borrowers that remained in a modification status at year end, 53% are designated as troubled debt restructures and 50% 57 per cent of risk rated sub standard.
The bank is following regulatory guidance and has designated loans as troubled debt restructures when the total of payment deferral modifications exceeds 180 days.
We've provided additional detail on loan modifications on page 20 of the Investor presentation.
Brian Macdonald will now have an update on loan production in our SBA PPP activity.
Thanks, Tony I'm going to provide detail on our fourth quarter production results, starting with our commercial lending growth for the quarter. Our commercial teams closed $140 million in new loan commitments down from $181 million last quarter and down from 306 million closed in the fourth quarter of two.
19.
The commercial loan pipeline ended the fourth quarter at $413 million up 7% from 386 million last quarter and up from $390 million at the end of the fourth quarter of 2019.
New loan demand continues to be negatively impacted by COVID-19, but our bankers reported increased discussions with customers on capital projects expansion plans and bank transitions, causing us to be cautiously optimistic this will translate into a higher loan volume in the second half of the year.
Loans, excluding SBA PPP balances decreased $45 million during the fourth quarter due to the relatively low new loan production and increased prepayment activity.
Pay offs and prepaid for $176 million for the quarter up from $131 million last quarter and $96 million in the second quarter.
For the full year loans were up a modest $61 7 million or one 8%, excluding the impact of P. P P and indirect lending which was discontinued in the first quarter of 2020.
Consumer production was $18 million for the fourth quarter down from $19 million last quarter and down from $49 million in the fourth quarter of 2019.
The decline versus 2019 was due to the discontinuation rate discontinuation of our consumer indirect lending business during the first quarter of 2020.
Moving to interest rates, our average fourth quarter interest rate for new commercial loans, excluding PPP loans was 332%, which is down 23 basis points from 355% last quarter.
In addition, the average fourth quarter rate for all new loans, excluding PPP loans was $3 four 2% down 22 basis points from 364% last quarter.
The mortgage department closed $57 million of new loans in the fourth quarter of 2020 compared to $49 million closed from the third quarter and $52 million in the fourth quarter of 2019.
The mortgage pipeline ended the quarter at 33 million versus $52 million in Q3 and $15 million in the fourth quarter of 2019 free.
Finance has made up 69% of the pipeline at quarter end.
Moving onto SBA PPP, starting with loan forgiveness on round one.
We continue taking forgiveness applications in waves for our 4600 plus round one PPP customers. The process is running smoothly, but labor intensive for those loans over 150000 size.
We anticipate having the majority of our customers invited to apply by the end of April and the bulk of around one PPP for giving us applications process by the end of August.
As everyone is aware of the recent stimulus Bill included a second round of PPP.
Open to accept applications for banks, our size on Tuesday January 19th.
We were through the peak of our customer applications by the 'twenty, one and open to accept applications from prospects on the 23.
Through yesterday, we had 2100 applications, including those in process $180 million approved through the SBA and $116 million closed and funded.
It's unclear at this point as to how many of the pending applications will move all the way through the lending process. However, assuming 50% of the applications not yet approved by the SBA and are progressing to closing the total volume of around two P. P. P would be in the $250 million to $300 million range.
I'll now turn the call back to Jeff.
Thanks, Brian as I mentioned earlier, we're pleased with our performance to date.
Our primary concerns remain with borrowers in the high risk loan categories, which is not news.
These businesses make up the vast majority of the increase for the non accrual and potential problem loan categories.
As in the past you will see these loan categories have been flow quarter to quarter as we worked with our customers.
I encourage you to focus on net credit losses, which historically have been relatively low due to our conservative risk profile and much discussed concentration management system.
While we are feeling better about the big picture at this point, we are still facing several uncertainties around the vaccines the economy, the political climate and ongoing social unrest in several of our core market for Metro markets.
Which could potentially impact our performance. However for now we're comfortable with where we sit and we believe the impact of the pandemic on our loan portfolio will be much more subdued than we originally anticipated.
As Don mentioned earlier, we believe our current capital levels are adequate and our robust liquidity provides us with a solid foundation to address challenges.
And also take advantage of opportunities.
We are focused on what we can control, including managing risk managing expenses and continuing to develop the technology, we need to deliver consistent long term performance.
That is the conclusion of our prepared comments. So Alan we are ready to open up the call now and welcome questions.
Any of you may have.
Thank you ladies and gentlemen, if you do have a question press. One then zero on your Touchtone phone.
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Our first question will come from the line of Matthew Clark with Piper Sandler go ahead.
Hey, good morning, everyone.
Good morning, Matt.
Maybe.
If we could just start on the expense run rate and kind of the technology reinvestment needs and the things you're working on this year.
I guess, how should we think about.
You know the puts and takes around expenses.
Okay.
Well, Matt look theres activity some color on that.
I will say just as a reminder, our.
Q4 expense run rate tends to be the lowest of the year and our Q1 tends to be the highest so basically goes.
First couple of quarters are higher than they tended to dropdown based off various factors.
Sure.
So.
Speaking of that we have to have some obviously a lot of.
Exit costs associated with branches in Q4.
We also are going to have some savings associated with not having those branches and in.
In Q.
Q1, mostly realized in Q2.
We do have a few exit costs left but we are we do have technology. We are also are having some expenses associated with the.
The.
Forgiveness for the new originations for the PPP. So those are going to there'll be some expenses in there. So you know looking looking ahead I foresee that.
Because of these expenses, we didn't have last Q1 that.
But having savings for the same time that reported it'd be kind of close to where we were last Q1.
Kind of net out but.
So some will depend on various factors as far as how much we do have to spend on on the PPP progress process.
And then just to clarify I mean, you are talking about.
For that $37 million run rate a year ago.
Excluding exit costs, which we'd likely back back out.
Well.
I'm, saying that Oh net will be closer to <unk> next to.
For Q1 of last year, then we.
Let me work for Q4, or even Q Q3 of this year so.
So net net it all out.
Got it okay.
And then just on the.
Opportunities to hire teams in your markets. It sounds like there's a fair amount of disruption in the northwest.
Are you in talks with any one of these days are you and are you.
Are you at a point, where you're you know you're close to hiring.
From bankers here in the near term.
Well, Matt you know from prior conversations that we're always open to consider high performing teams.
Joining us in ways, we have successfully done that both in Seattle and Portland.
For typically always in conversations with folks from the industry, whether they be people may be looking for or change or.
Quite frankly other banks.
So it's really.
Up to us to determine the timing because up till now we've been reluctant to bring on teams.
With all the uncertainty.
Around us.
And.
I think it's possible that we could do something this year, but we haven't been rushing to do it credit were waiting for for everything is settled down first.
Okay, and then just on the M&A side of the equation.
Can you give us an update there has have conversations started to pick up more meaningfully.
And do you expect to get something done this year.
Yeah.
Much like everybody else, we are hopeful debt.
There will be more activity as the year progresses, probably more in the latter part of the year, but we've been.
<unk> been pretty diligent throughout the whole COVID-19 experience keeping.
In contact with people, we know in the industry.
So they can see how we're doing and what we're up to and that has served us well over the past couple of years in terms of.
Keeping people informed so that if they decided to do something we get a call.
I think the conversations may have gotten a little bit more interesting in the last month, but I wouldn't say it's.
It significantly different.
Okay, and then Don can you just give us the remaining amount is net net P. P. P fees left from round one.
Yes, it's I think it's a little over $15 million.
Okay. Thank you.
Yeah.
We'll go next to the line of Jeff <unk> with D. A Davidson go ahead.
Thank you good morning, guys.
Hey, Jeff.
A question for I wanted to follow up Don just to clarify the expense number you're saying that that's closer to Q1.
Of 'twenty versus Q4 of 'twenty and then given what you said typically.
So confirming the balance there and then the trend of that would be it falls off from the Q1 level of 'twenty. Once you the balances of 21.
Yes.
Yes, Jeff I tried to clarify that.
So, yes, I expect expenses to be closer to Q1 of 'twenty for the next couple of quarters based off the cost and then hopefully we can continue to work that down.
Down over overtime, but I do expect that.
It could be close for Q1 based off offsetting.
Factors.
Debt net orders hit us in the first part of the year.
Yeah.
Got it kind of strip out the <unk>.
Some of the exit costs, but.
That's helpful.
For me if there's three factors the name, but I'm just trying to give you an overview of that.
No I appreciate it John.
On the branch closures of what you've identified or what you're what you've closed.
Probably a smattering of decisions there but.
I don't know if it was like guiding you base that judgment on from a profitability metro versus rural proximity to other branches is was there a.
Some themes of what Youre looking to coal from the network.
I think what you're primarily saw us do Jeff was.
<unk> branches that were.
Close to other it was based on proximity for the most card.
And I think that is.
Partially a result of some of the.
So the new view, we haven't had this year into our customers' activities.
A lot of people, obviously signed up for online and mobile.
And we are realizing that.
The number of branches.
It does not need to be as robust as it used to be.
We will continue to look at the rest of the footprint.
I suspect over time.
You will see us take continues.
Well chip away at the big broad footprint that we have where it makes sense.
Okay.
And.
Jeff the.
The reinstatement of the buyback does that.
Is that dark in the view of sort of M&A prospects or is it simply just a.
We got a we got to keep that tool.
Backup in.
Accordingly use it just.
I guess, we shouldn't overreact to that being reinstated it's more a product of some comfortably about the macro environment.
Yes, yes, I think that was a good way of putting it is just one of the tools we have.
And the right circumstances, we want to be able to use it.
If it if it makes sense, but no I don't think you should overreact to us announcing that were for.
We're bringing it back Dan anything you want to add to that.
No I think you covered that.
Yeah.
Okay and last one just maybe for Brian.
It seems you know you've got.
Got a little.
You know kind of creep in the MTA figure.
But with the recapture of my guess is.
Those that migrated to non accrual were certainly on watch and reserved for in and just.
Understanding that.
You know that the direction of the reserves, there's more indicative book of.
Growing comfort then it may be watching the NDA level anything you can expand on kind of reserve levels.
Additional release into into 'twenty one.
Don maybe you want to take the the reserve piece and then maybe Tony comment on that.
Credit quality on me I apologize, but Tony sorry about that yeah no problem. So.
I'll talk about the provisioning.
As I mentioned.
Jeff.
What it will be a lot of factors, including what kind of loan growth, we have but as far as the.
The current increase in NPA is there even though they were added there wasn't.
Our required provisioning for those because of the collateral valuation on them. So we felt pretty good about not adding any for those.
Today, we're going to watch carefully the growth on the economy, especially our industries that are and.
For a more challenges than others.
We we thought there was more favorable outlook quarter over quarter.
We did not at the current level of.
Going on in the local economy, we just didn't feel like we could release too much honestly there were some had to happen because there's nothing else the loan balances.
We.
We didn't feel it was right to release too much of that currently but I can see that if we continue not to have.
Charge offs.
So at some point that will the provisioning will have to come back in but.
You know, it's hard to say, whether the charge offs are just postponed or they're really not going to be nearly as high as we initially thought so it's kind of early in the game I don't know Tony you want to add any more to that.
Yeah. Thanks, Thanks, Don Yeah, Jeff just in answer to your question I think if I don't answer it correctly, let me know, but or what youre looking for but I feel like we are the bank had pretty much. The identified all the credits that were early at risk although loans were early at risk.
By the end of the second quarter, and so really the second half of the year has been largely just managing that portfolio and watching the more impacted borrowers migrate to the worst risk rating categories, including of course special mentioned substandard and then obviously looking at non accrual and TD or situations. So.
We feel pretty good at the end of the end of the year that the debt portfolios identified segmented properly and as we as we move forward. It's just a matter of managing a maybe a much smaller population of loans that we might have originally thought we'd have earlier in 2020.
Makes sense thanks, Tony.
And ladies and gentlemen, as a reminder, if you do have any questions. Please take this opportunity now to press. One then zero on your Touchtone phone.
We'll go to the line of Jackie Bohlen with <unk> W. Go ahead.
Hi, good morning, everyone.
Jackie a pallet I apologize if this is a little bit technical of a question.
Kind of in effect the decline in indirect auto have on debt and the released this quarter.
From a provision standpoint.
Just broadly if it does well.
Jack if you could just probably take that.
Provision expense, we have I don't think it was.
It might have a higher percentage I don't remember off top my head what percentage we.
We're applying to indirect auto probably higher than.
What we've got in there at 2% because it's much higher than let's say commercial real estate.
Yeah.
I don't remember exactly what it was but if you take that decline in balances.
Of the $27 million and take it say.
It might be 3%.
Might be closer to two what we allow for that that might be an impact from that okay.
I guess, where I'm going just broadly.
Wondering if.
Part of that portfolio being in runoff mode absent any other changes is going to cause the ratio itself to kind of drive gradually trickle down as the.
The risk profile.
I would say marginally but were also down to about $200 million for the whole portfolio. So it'll have less and less of an impact.
Okay. Okay.
Thank you.
But that's you C&I loans that were called out.
Having said the decline in the quarter that you significant relationship was that intentional or was that.
Driven by something else.
In terms of non euro part.
Tony you might punching power.
Yeah actually Brian you might you might have a better idea on that that's the ones that are that paid off in the in the quarter that the larger relationships.
Jackie this is Brian.
We did have elevated payoffs and paydowns in the quarter and.
Both of the large ones I'm thinking of where both business sales.
<unk>.
But we also had some some refis, which wasn't pleasant those two but that was the other big driver kind of coming back in.
Perhaps just as the economy is.
People have a little better visibility of course rates are very low so.
We didn't see a lot of refi activity, obviously in Q2 or Q3, but we saw more in Q4 and then.
A resumption of some of the business sales we were seeing.
Last year.
Okay.
I mean, just based on the pipeline numbers you gave it sounds like setting payoffs aside from an origination standpoint, it sounds like you're fairly well situated in taking share and then maybe more optimistic for a pick up as things start to open up hopefully in the latter half.
Is that a good characterization.
That's true.
Right now of course, we've got everyone focused on getting their customers through PPP, although that was a much shorter.
You know I guess window of time, where we are fully focused on it we're already well over the a high point in and you know this week closing a lot of loans, but by the time, we get get into next week I think we won't be back to normal because we'll still be working on it but much less of a of a focus on it.
And with the vaccine rollout in and the economy continuing to open up we do see the second half of the year.
With a lot more potential.
Jackie you know that you probably never hear us use the term exuberance in terms of our future outlook.
But I do.
Want to remind everybody that.
For the the overlay of COVID-19, the region was performing at a pretty high level.
Before the pandemic and there are still a lot of activity going on underneath the surface.
We.
Yeah, we just saw.
New article about the Seattle market being.
In the top 10, most active economies in the country I realize that were for overshadowed with the pandemic for when that starts to.
We start to be relieved of that pressure.
There is.
A lot of potential in this region.
And remember that in the Metro markets, we're still relatively new so theres still a lot of work to be done there.
And also not to forget when we did PPP one we got a good chunk of new prospects out of that and they're still coming across the transom.
It's not been a quick close because of everyone being remote.
Being distracted with where they are so.
And on top of that we've got Microsoft and Amazon are still building and buying all over the footprint. So and housing prices are still very strong here you know that so I think all of those things.
To that cautious optimism that Brian talked about in the second half of the year, if we get the vaccine going in the right direction.
Okay, great. Thank you Joey and Jacky.
Okay.
As Don just while we're talking I did check and about $500000 of the release this quarter was due to the decline in indirect auto balances.
Okay, great. Thanks Bonnie.
Thank you everyone.
Thank you.
We have no further questions in queue at this time.
Well, if there's no more questions and then we'll wrap up this quarter's earnings call. Thank you all for participating we appreciate your support and your interest and I think we're going to see or at least talk with some of you in the coming weeks. So looking forward to that thank you very much for joining us.
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