Q3 2021 Heritage Financial Corp Earnings Call
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Good morning, Thank you for standing by and welcome to the Heritage Financial Corporation third quarter 2021.
Earnings call at this time, all participants are in a listen only mode. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. If you would like to ask a question. During this time simply press star followed by the number one on your telephone keypad, if you would like to withdraw.
Draw Your question Press Star followed by the number to you.
He's note today's call is being recorded I would like to now hand, the conference over to your first speaker today, Jeff Deuel CEO of Heritage Financial Corporation. Please go ahead.
Thank you sure good morning, everyone and Hello to all of those who may listen.
Listen later this is Jeff Deuel CEO of heritage.
Attending with me today are Don Hinson, Chief Financial Officer, Brian Macdonald, President and Chief operating Officer, and Tony <unk>, Chief Credit Officer.
Our 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 third quarter investor presentation on the Investor Relations portion of our website, which can be found at heritage Bank N W. Dot com.
We will reference the presentation. During this call. Please refer to the forward looking statements in the press release.
We are pleased with our.
Our financial performance for the third quarter, while loan growth X P. P. P. At an annualized rate of two 6% was more modest than we had hoped to achieve we are getting our fair share of new deals and because of our good work with P. P. P. Several of them are marquee names in the region.
Heading into the end of the summer.
We saw an upswing in the pipeline and expect the pipeline to continue to grow for the balance of the year and into 2022.
We continued to focus on managing expenses with good success and improving expense ratios note that F. T. E. Overall has declined 9% since the end of 2019.
Looking forward, we expect NII to remain relatively flat in the 37% to $38 million range each quarter through 2022. Additionally.
Additionally, as of this month, we are wrapping up the branch consolidations, we talked about last quarter.
Once completed we will have ridden.
<unk> branches by 21% since September 2020.
In addition, we have sold multiple bank properties and we have also arranged for the sale leaseback of our headquarters campus in Olympia, which is expected to close in December of this year.
Notably our long standing focus on credit quality and actively manage.
And our loan portfolio continues to play out well for us as the pandemic recedes that discipline has enabled us to report more favorable credit trends and recapture some of the reserve build from last year.
We will now move on to Don who will take a few minutes to cover our financial results.
Thank you Jeff.
As Jeff mentioned overall profitability was very positive in Q3, I will be reviewing some of the main drivers of our performance for the quarter.
As I walk through the financial results unless otherwise noted all of the prior period comparisons will be with the second quarter of this year.
Starting with net.
Interest income there was a decrease of $2 9 million due mostly to a decrease in income from PPP loans and the recovery of interest from payoffs of non accrual loans, which occurred in Q2, and therefore inflating Q2 income.
Partially offsetting these factors was an increase in income from investment securities.
This increase was due in part to income from a large prepayment penalty we realized on one security.
While I'm on the topic of investments I want to point out that during Q3, we transferred $245 million of securities.
The available for sale to the held to maturity classification.
This was done to mitigate.
The potential impact of market price volatility on capital.
In addition, we are classifying many of our new purchases as held to maturity. So that our held to maturity portfolio was 29% of total investments as of quarter end.
The net interest margin decreased due mostly to the impact of PPP loans in the non accrual loans.
Previously mentioned as well as lower core loan yields and a higher percentage of excess liquidity.
Overnight interest, earning deposits increased 21, 9% of average earning assets.
Compared to 15, 2% in the prior quarter and six 7% in Q3 2020.
Trends.
And the composition of average earning assets as shown on page 27 of our investor presentation.
Removing the impact of discount accretion and PPP loans, the yield on loans decreased 26 basis points.
However, 16 basis points of this increase was due to the difference in the impact of nonaccrual loan interest recoveries.
Quarter over quarter.
Brian will discuss loan production and balances, including PPP loans in a few minutes.
We continue to work down our cost deposits, although we were very close to being as low as we're going to get.
Our cost of total deposits decreased nine basis points in Q3 down one basis points from Q.
Q2 levels.
More information regarding deposit growth and cost deposit can be found on page 25 of our investor presentation.
We were very active in stock buybacks in Q3, repurchasing two 3% of outstanding shares for a total dollar amount of $20 6 million.
Even with these buybacks all of our regulatory capital ratios remain strongly above.
While our thresholds.
The combination of strong liquidity and capital gives us tremendous flexibility as we continue to grow the bank.
And you can see page 29 of the Investor presentation for more specifics on capital and liquidity.
Noninterest income saw a slight decrease primarily due to lower mortgage loan sale gains.
Well accounting, partially offset by higher fee income.
Fee income increased mostly due to higher interchange income as activity has increased with our economies in the Pacific northwest opening up.
Mortgage loan sale gains.
Decreased due to lower margins and a higher percentage of loans being held in the portfolio.
We continue to see nice improvement in our overhead ratio.
Due to the combination of expense management measures and asset growth overhead ratio decreased to 2.0% to 4% compared to 2.06% in the prior quarter and $2 one 7% in Q3 2020.
Noninterest expense increased from the prior quarter due mostly to <unk>.
Elevated costs related to the upcoming branch consolidations.
A significant impact to our earnings for Q3 was the reversal of provision for credit losses in the amount of $3 1 million. Although this was much lower than the reversals in the prior two quarters.
Factors for the provision reversal includes a decrease in non accrual loans.
<unk> a continued improved economic outlook.
I will now pass the call to Tony who will have an update on credit quality metrics.
Thank you Don in the third quarter, we continued to see credit quality improve across our loan portfolio. However, the improvement was somewhat muted by the continuing impacts of the delta varying of Covid.
We also note that many of our customers remain impacted by the related labor shortages and supply chain issues.
For the third quarter non accrual loans declined by $9 4 million or 27% from the prior quarter.
Non accrual loans are now down 55% from our December 31 2020 levels.
As of September 30th non accrual loans totaled $25 9 million or six 5% of total loans.
$7 million of the reduction was a result of returning in owner occupied commercial real estate relationship back to accrual status. This borrower was heavily impacted by Covid and is now showing significant.
Improvement in their financial performance.
The remainder of the decrease.
It was due to paydowns and payoffs of multiple loans all of that have been subject to long term workout strategies and most of which were not pandemic related.
The addition of new loans to non accrual status in the second quarter was $293000.
Which is consistent with the low levels that we experienced in the first two quarters of 2021.
Other than nonaccrual loans, the bank has no other nonperforming assets.
Criticized loans those risk rated special mention and substandard declined by approximately 8% or $18 $4 million since the end of.
The second quarter and 25% from December 31, 2020.
While improving criticized loans remain elevated when compared to pre pandemic levels.
At $217 $2 million criticized loans or approximately $75 million higher than December 31, 2019.
<unk>, which we considered to be representative of our pre pandemic our normal levels.
The two largest components of criticized loans impacted by COVID-19 or hotels and restaurants.
These two industry categories, we have $88 $7 million of criticized loans.
While we are seeing improvement across these portfolios.
Many borrowers remain negatively impacted and are not yet at a level of performance that warrants a return to pass rating.
Particularly in the hotel industry, the Delta surge of Covid in the third quarter slowed down their progress towards a pre pandemic level of performance.
For more detailed information on loans in the industry categories most impacted.
<unk> by COVID-19, please refer to page 22 of our Investor presentation.
During the third quarter, we experienced net charge offs of $393000.
Total charge offs were 947000.
With 689000 attributed to one agricultural relationship that was not COVID-19 impact.
Yeah.
These charge offs were partially offset by 554000 in recoveries spread between our commercial and consumer portfolios.
Through the nine months ending September 30th net charge offs of $60000 remains very low when compared to our historical norms.
In summary, we're pleased.
With the improvement in our credit quality metrics during the quarter. However, the surge in Covid cases, and the related labor and supply chain issues slowed down the recovery progress for some of our borrowers.
The economies of Washington, and Oregon have been resilient during the pandemic and we are expecting to see continued positive credit quality trends over the next several quarters as Covid case.
Cases subside.
I'll now turn the call over to Brian who will provide an update on loan production and our SBA PPP activity.
Thanks, Tony I'm going to provide detail on our third quarter production results, starting with our commercial lending group for.
For the quarter, our commercial teams closed.
<unk> $271 million in new loan commitments up from $151 million last quarter and up from $192 million closed in the third quarter of 2020 the.
The commercial loan pipeline ended the third quarter at $547 million up from $492 million last quarter and.
Up from $386 million at the end of the third quarter of 2020.
We experienced an increase in new loan requests from customers and prospects during the quarter as expected due to the governors of Washington, and Oregon lifting many of the pandemic restrictions at the end of June and our bankers being more active.
With in person customer meetings.
Loans, excluding SBA PPP balances increased $24 million during the third quarter and although a modest increase is the first quarterly increase in loans, we have seen since the first quarter of 2020.
Higher loan production during the quarter was offset by increased.
Pes and pay offs. This in conjunction with the runoff in the indirect consumer portfolio continues to weigh on the overall loan growth rate.
Adjusting out the impact of PPP and indirect loans during the quarter would have resulted in a growth rate of over 5%.
Please refer to slide 19 of the Investor presentation.
<unk> for additional detail on the change in loans during the quarter.
Consumer production the majority of which are home equity lines of credit was $30 million for the third quarter up from $23 million last quarter and up from $19 million in the third quarter of 2020.
As a reminder, we discontinued our indirect.
Consumer lending business in the first quarter of 2020, and the balances continue to run off.
Including a $22 million decline in the third quarter.
Moving to interest rates, our average third quarter interest rate for new commercial loans was $3 five 1%, which is up 13.
<unk> 13 basis points from 338% last quarter.
In addition, the average third quarter rate for all new loans was $3 four 2% down three basis points from 345% last quarter.
The mortgage department closed $44 million of new loans in the third quarter of 2000.
<unk> 21, compared to $49 million closed in the second quarter of 2021 and $49 million in the third quarter of 2020.
The mortgage pipeline ended the quarter at $55 million versus $41 million in Q2 and $51 million in the third quarter of 2020.
Refinances made up 77.
7% of the pipeline at quarter end.
Moving on to SBA PPP forgiveness.
SBA PPP forgiveness process continues to progress smoothly ash.
As shown on slide 21 of the Investor presentation at quarter end, we had only 2% of around one PPP balances outstanding.
And we were already repaid on 35% of round two PPP balances in.
In addition to the extent we have filed claims with the SBA. These loans have been processed and paid very quickly I'll now turn the call back to Jeff.
Thank you Brian as mentioned earlier, we're pleased.
With our performance to date, we're also happy to be pivoting away from our defensive posture of the past 18 months.
While many of our employees are still working remotely the production teams have been able to move away from their focus on PPP forgiveness and reset their focus on managing their customer relationships and developing business.
While business activity in general has been muted by customers and prospects working remotely we are seeing a general re engagement, which points to a healthy return to normal.
As mentioned earlier, we're seeing a nice upswing in our pipeline pipeline across the bank with deals coming from existing customers in two high quality prospects.
We're prepared for a high single digit loan growth and we are optimistic we will get back to that level of historical loan production.
We have worked hard to reduce our expense base going into 2022, and our full focus is on organic growth supported by more efficient operations.
We are also ready to pursue other op.
As for growth in our three state region, when we see them as Don mentioned earlier, our capital levels and our robust liquidity provides us with a strong foundation to address challenges and to take advantage of opportunities.
That concludes our comments today, so tia or Shar, we're ready to open.
Up the line for questions from people on the call if we could.
Absolutely we will now begin the Q&A session.
I'd like to ask a question. Please press star followed by one on your touch on keypad, If Randy reason you would like.
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As a reminder, if youre using a speakerphone. Please remember to pick up your handset before asking your question and I will pause here briefly to allow questions to generating Q.
The first question is from the line of Jeff Lewis with D. A Davidson you May proceed.
Thank you good morning.
Good morning, Jeff question on it.
Hi, Jeff.
Yeah.
For Dawn.
Thanks for the slide 27, just wanted to confirm that core.
NIM.
Does that exclude I'm, assuming it does not exclude a P. P P impact in interest recoveries.
Jeff No it does not.
So again or would you have to check with you.
You can.
We have in the back of the.
Our earnings release, we have a supplemental schedule kind of it for the non-GAAP piece that shows the dollar amount of the P. P. P and so you can get that information there and see what the actual yields were on PPP. So if you wanted to back that out.
Okay, and so the interest recoveries were there any another one came back on.
On to accrual, but were there any recoveries.
In the current quarter and could you remind us what that number was last quarter, yes, so for on the loan.
Piece it was.
It was 18 basis points impact in.
In Q2, and it was down to two basis points impact.
So again as I.
I mentioned that the the yields were down 21 basis points up 16 basis points has to do with the kind of quarter over quarter change in the recoveries on.
On non accrual loans.
Mhm Okay.
Great. Thanks, and just I guess your thoughts on the on the core margin is done.
I don't know if I missed that.
But just.
Or are we kind of settle in here.
Yeah, it's going to I think it's going to continue to fall again, we're getting a.
The PPP loans themselves had had another big impact.
And I think it was $8 million in Q3, and that's going to I.
Thank fall significantly in Q4.
The yield on the PPP loans was close to 8%.
So.
That's just going to impact us quarter over quarter. In addition to our continued large amount of liquidity that we have so you know.
Our goal is to continue to grow loans and investments as needed to <unk>.
<unk> offset some of the decline in PPP, but it's going to it's going to fall some more.
Into Q4, possibly into Q1 also but.
We are looking at.
Flattened out.
Over sometime over the next couple of quarters.
Got it and Brian.
The.
<unk>.
On slide 19, you've got the payoffs in Prepays in the in.
In the third quarter, how does that number compare I think you just said it was up from Q2, but do you have the combined number what would that.
Figure was.
Yeah, Q Q2 combined to prepay some pay.
It was about $168 million and so if you look back to Q1. It was kind of on a monthly basis. It was mid 40 million range and then you know.
$50 million range in Q2, and then Q3, you know got up over $60 million I think it comes out it's about 62 million average.
Per month.
And a lot of that Jeff.
Is the economic activity in the region, we're seeing you know more.
Sales of buildings and businesses similar to what we were seeing pre pandemic.
Gotcha.
Okay and last one for Jeff.
Obviously, the merger activity in the area.
Buyers potential potential buyers, maybe that pool is shrinking.
Revisiting the the M&A topic for you as you see those Congress.
Conversations anything to kind of update or just your thoughts on how the landscape is evolving.
Well.
I guess, it's an understatement to say that the announcement that the.
Came out last week was a surprise.
I think for for many people.
That does change the landscape here it does show, there's a bit more activity than before.
I think what it might do Jeff is it might be a catalyst for for our conversations.
And going into 2022, but I think maybe for us.
The landscape has improved our situation from the standpoint of being a potential acquirer.
Because you know there's there's two potential competitors that are busy.
Glaciers busy.
And first interstate's busy so I think.
Think it may be a good time for us to take advantage of opportunities as they present themselves without having a lot of competition.
Okay I.
Appreciate it thank you.
Thank you.
Thank you Mr. Lewis.
Next question is from the line of Matthew.
Clark with Piper Sandler you May proceed.
Hey.
Tom.
Good morning.
First.
Sorry first one for me just around.
The higher payoff activity.
It sounds like some of it's you know.
Businesses selling.
Selling the buildings, but I guess, how much of the incremental pressures coming from <unk>.
Some other banks that are willing to do longer term fixed rate stuff and are you having to compete at all are you just letting it go.
Brian you want to take that one.
Sure.
<unk>.
We are continuing to get you know in addition to the building sales business sales.
We're also continuing to get paid off on some of our key.
Credits, where.
Customers are looking for refinances.
Where the terms were offering arent quite as aggressive as the competition, Matt I wouldn't say, that's hugely outsize to what it was a couple of years ago, where we were experiencing.
The same sort of same sort of thing we see that a lot on it.
Maybe it's a multifamily property or non owner.
Those are pretty where somebody's looking to refinance and man take cash out of it that sort of thing we're not.
Sure.
Always as competitive as other other players and some of those markets. So there is a uptick in activity there versus what we would have a year ago, but I wouldn't consider it oversized the.
Our biggest.
A couple of big changes versus a year ago. If you look at slide 18 of the of the Investor presentation that C&I utilization rate still remains quite low so even on the new C&I deals that were booking oftentimes there is a line in.
And as a significant line.
But it's very likely it also has a very lower or even a zero balance. So so that's that's impacting some of the growth.
And then just in general the commercial demand.
Is still relatively low the customers have a lot of cash and if you look at the changes.
And sometimes categories.
Of loans during the quarter slide three of the of the earnings release had a table on them, but we saw good growth in owner occupied.
Number one we're still seeing that and we have a really nice amount of owner occupied real estate and the pipeline the commercial was.
As in flat and then some growth in Perm non owner, a little bit and mortgage and then of course, some consumer declines and so that's really what I see is just still still some soft demand on that.
This is primarily around our existing customer base on.
Commercial non real estate non owner.
Really for non real estate type requests.
Okay.
And then the.
The increase youre seeing in commitments within commercial.
C&I.
And CRE owner occupied not all are what are the types of kind of underlying.
You know properties.
We're seeing the biggest uptick in here more recently.
Yeah on the on the owner occupied side, it's really across the board I mean of course some of the most impacted industries wouldn't be included in that but once you get outside of that it's a it's a pretty broad.
Broad base.
So businesses.
Many are busy and looking for additional space to expand or acquire the properties that are currently leasing.
We have a big big pipeline on the SBA 504 side.
Several multiples of what we would normally.
Commercial.
Of course.
We're taking the 50% bank financed portion is the permanent loan there.
And it's really across the board as well, Matt I mean, we're seeing really good activity in our major Metro markets King County.
Location of Seattle Bellevue.
But also strong up and down the footprint.
Okay.
And then.
As you look out to next year.
Your earnings comparisons are obviously challenged I mean.
Partly.
From how well you guys did in <unk>.
<unk> P and the contribution there I think that's like 80 cents a share this year roughly.
And then another 55 cents.
Benefits from negative provisioning so.
Can you just you may have said it in your prepared comments and I apologize because I was on another call as well but.
I assume.
Your expectation is to hold expenses flat next year.
It's not maybe do a little better and then just on the high single digit loan growth I think you mentioned Jeff.
Timing at which you think you can restore that.
Yeah, Matt Good question and Brian you might want to join in on the response.
But that's partly why I also said our full focus is going to be on organic growth, we need to get the engine.
Going at full throttle.
Think that we've had are fits and starts over the summer.
Recalling that the governors allowed us to open up in early July.
And then when everybody.
He realized that they were free to move around everyone went on vacation in August including most of our employees. So.
That's the the fits and starts over the summer, but I think once everyone hunkered down in September.
We've started to see a nice.
Nice upswing in not just the pipeline, but Tony Brown.
Brian and I make up the executive loan committee, where we see the largest deals or the largest relationship activity in.
We've all three of us been remarking to each other how much more activity. There has been in the last couple of months than we've seen in a while which is.
It's just kind of intuitively showing that we're heading there.
Right direction, but I think.
Brian May have some some anecdotal.
Feedback for you on this but I think we're just going to see it gradually continue to increase.
If if we're fortunate and it plays out the way we hope it will that will start getting closer to more historical levels of.
Production, probably early in the new year, Bryan anything to add to that.
It just maybe tying in a couple of the specifics we ended the quarter with a pipeline of $547 million up from 492 and more loan closings during the quarter than Q2, So we're heading.
Being in the right direction get up in that high single digits, we've got to get the pipeline up from that $5 47 to something over $600 million and then the loan closings from.
Where they were last quarter, which was around 90 million average a month to something a bit over 100 million.
It depends on on payoffs so.
We're heading in the in the right direction and and that's where we're all focused on our teams are focused and by focused I mean, just trying to be as active.
Our calling as we can be to turf up as many opportunities and get in front of our clients and make sure that we're.
You know just just providing that extra touch to try and get additional opportunities. So.
You know if we can do that we're up in the high high high single digits. If we can get the pipeline up another $50 million to $60 million in and bump the closings.
Modestly.
Again, it on a monthly basis.
Got it thank you.
Okay.
Thanks, Matt.
Yes.
Thank you Mr. Clark.
Once again, ladies and gentlemen, if you would like to ask a question. Please press star one at this time.
There are no additional questions waiting in the queue I would now like to pass the conference back to Jeff.
Well sure. Thank you very much for moderating for us and thank you to everyone who called in we we appreciate your your interest in our story and we'll see some of you are.
What visually see some of you in the.
In the coming weeks at some of the events.
And we look forward to talking with you then in greater detail. So thank you everybody and goodbye.
That concludes the Heritage Financial Corporation third quarter 2021 earnings Conference call. Thank you all and enjoy the rest of your day.
<unk>.
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