Good afternoon. My name is Elisa, and I will be your moderator for the conference call today. At this time, I would like to welcome everyone to the Heritage Financial Investor Call. All lines have been placed on mute to prevent any background noise. After the speaker's 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 your question, please press star, followed by the number two. Thank you. Bryan McDonald, CEO of Heritage Financial, you may begin.
Thanks, Elisa. Good morning, everyone, and thank you for joining us. We are here to talk about the recently announced combination between Heritage and Olympic Bancorp, the parent of Kitsap Bank. During today's call, we will be referring to a presentation detailing the transaction, and I would encourage everyone to access this on our investor relations website. Attending with me are Don Hinson, Chief Financial Officer, Tony Chalfant, Chief Credit Officer, and Jennifer Nino, Chief Accounting Officer. As a reminder, during this call, we may make forward-looking statements which are subject to economic and other factors. You can find the investor presentation and press release on our corporate website, and important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within these documents.
Yesterday, after the market closed, we announced an agreement to acquire Olympic Bancorp, the holding company of Kitsap Bank, a 117-year-old community bank headquartered in Port Orchard, Washington, with total assets of $1.7 billion. Kitsap is a high-quality community bank operating primarily in the western Puget Sound region through 16 branches and one loan production office. Kitsap's geographic locations, coupled with their operating model, make them a uniquely attractive merger target for us. The merger is a win-win for both sets of shareholders, with material benefits from our added scale, deeper market presence, and strong financial returns on a pro forma basis. The strategic fit of this merger is exceptional. Several key aspects of Kitsap's business demonstrate how well we are aligned with them. Both Kitsap and Heritage are centered on relationship banking, coupled with a strong commitment to community.
Kitsap has operated for over 100 years, and Heritage for nearly 100 years. When you execute a relationship banking strategy for a century, the result is typically demonstrated through loyal, low-cost core deposits. Kitsap's cost of total deposits is 1.09%, which is lower than Heritage's 1.40%. Another feature of this longevity is a commitment to credit. A bank operating for 100 years has been through many cycles and survived and improved along the way. This is true for both Kitsap and Heritage. Both organizations have clean credit portfolios and a long track record of conservative underwriting. Kitsap's current NPA to assets ratio is 0.01%, and finally, this is a great geographic fit. We will extend our footprint into adjacent communities in the western portion of Puget Sound, where we currently have no branch presence, and Kitsap Bank has strong market share.
There is overlap in two metro counties on the Interstate 5 corridor, enhancing our strong position in these markets. We are planning on retaining the Kitsap Bank name at all branches except for the offices overlapping with existing Heritage Bank offices in Pierce and King County. Before I pass the call to Don, I want to share a bit about our past relationship with Kitsap Bank, its leadership, and how this opportunity presented itself. For many years, our teams have often crossed paths at various banking association, advocacy, and community events, and of course, we also compete for clients and banking talent. Over these many years, we at Heritage have developed a deep respect for Kitsap's leadership and employees, and a strong admiration for their bank.
So Kitsap has been on our radar for a while now, but as a 100-plus-year-old privately held company, you just never know when or if an opportunity like this will surface. Let's just say we are very excited to put this transaction together and share this news with you today. I'll now turn the call to Don Hinson, who will review the financials of the transaction.
Thank you, Bryan, and good morning, everyone. I will touch on the key financial terms of the merger, as well as expected financial metrics. The merger is all stock with a fixed-exchange ratio, whereby shareholders of Olympic Bancorp will receive 45 shares of Heritage Common Stock for each share of Olympic Common Stock. As a result, we will issue approximately 7.2 million shares of Heritage Common Stock. Based on our stock price of $24.64 as of the close of market this past Wednesday, September 24, the implied deal value is approximately $176.6 million. At this stock price, the price is 151% of Olympic's tangible book value, or 103% if you exclude their AOCI. The value of the merger will fluctuate until closing based on the value of Heritage's stock price.
We expect closing to occur in Q1 2026, following which Olympic shareholders will own approximately 17.4% of the combined company. We believe that this is a well-priced transaction with attractive returns for our shareholders. The fully phased-in EPS pickup is projected to be approximately 18% in 2027. As always, we have been realistic and diligent in determining our modeling assumptions. We project the tangible book value dilution of under 10% at closing to be earned back in approximately three years using the crossover method. We are targeting 35% cost savings based on the identified efficiencies of combining our banks. Approximately 45% of these cost savings are expected to be realized in 2026, and we will have 100% realized in 2027 and beyond. With our history of executing on strategic acquisitions, our teams have extensive experience in acquisition, due diligence, and integration.
The Heritage team conducted thorough due diligence with experienced associates from across the bank participating in the effort. As part of the process, our credit review team performed a comprehensive review of Kitsap Bank's loan book. This included a detailed review of 53% of Kitsap's loans, including 88% of commercial loan commitments of $5 million or greater, and 100% of criticized loans. Kitsap has a history of maintaining strong credit quality, and our teams found their approach to credit underwriting and monitoring to be sound. Page eight of the investor presentation discloses some of our key assumptions related to the modeling of the transaction. I want to point out that based on the new accounting guidance expected to be released in Q4 from FASB, we did not double-count the loan credit marks as is required by current GAAP. In addition, we expect to redeem Olympic's $35 million of subdebt.
Regulatory capital ratios post-closing are expected to remain comfortably above well-capitalized thresholds. I will now pass the call back to Bryan.
Thanks, Don. To wrap things up, I would just like to restate we are extremely pleased with this unique opportunity to bring Kitsap Bank to the Heritage family. We are excited to join forces and capitalize on the various opportunities that will come from the combination of two distinguished bank brand names in the region. It will be fun to watch what we're able to accomplish together. With that said, Elisa, we can now open the line for questions from call attendees.
Thank you. At this time, I would like to remind everyone, in order to ask a question, press star, then the number one on your telephone keypad. We will pause for just a moment to compile the Q&A roster. Your first question comes from the line of Ryan Payne with D.A. Davidson & Co. Your line is now open.
Morning, Ryan.
Morning. This is Ryan Payne on for Jeff Rulis. Starting with rate sensitivity, does Olympic alter your rate position? I believe you're slightly asset-sensitive now.
Yeah, overall, we're fairly neutral. We don't have a lot of movement either way. And actually, Kitsap is very similar in their asset sensitivity. So they're pretty neutral in their interest rate sensitivity models. So we're going to fit in right in with them on that.
Got it. Helpful. And on the fee-income side, do you see any opportunity to expand or cross-sell any products between the two organizations?
Ryan, nothing specific to note. Both operating models are pretty similar in terms of the products and services offered. And we didn't model any additional revenue synergies as we were doing our modeling. Of course, over time, we do hope to deploy their liquidity into additional loans. So we do expect that. But outside of that, no specific fee-income opportunities.
Got it. Last for me on capital priorities. Do you see any increased appetite for more M&A going forward? I mean, this sounds like a pretty specific opportunity. So just anything to add on future appetite and how conversations have been going?
Sure. I guess what I would say is that our first priority is to make sure this transaction is a success. As Don noted, we think we can get the deal closed early in 2026 and be converted the second half of next year. We are continuing to engage in conversations, and if something attractive surfaces, we would consider it as we always do.
Got it. Thank you. I'll step back.
Thanks, Ryan.
Thank you so much for your question. The next question comes from Ashley Aloupis with Piper Sandler. Your line is now open.
Hi, this is Ashley Aloupis on for Matthew Clark. Congrats on the deal, guys, and thanks for taking my question.
Sure.
I just want to ask about the cost savings. You estimate around 35% of cost savings. Can you provide some insight into the sources of these cost savings and kind of the timeline for the systems conversion to occur?
Sure. Don, you want to take that one?
Sure, well, it's pretty much the standard cost savings as far as there's going to be, obviously, back room. There's going to be FTE reductions in the back room, but there's also going to be the systems, the core systems, and a lot of other systems that are duplicates we wouldn't need going forward. So I would say those are probably the key drivers to those cost savings. There's not a lot of branch overlap, so there's not going to be a lot of closing of branches, but it's mostly going to be both systems and people.
Awesome. Thank you for that color. So another question. Looking at the $10 billion mark, it looks like on a pro forma basis, you'll be around $9 billion in total assets after close. And this seems like a good deal to offset in terms of building some scale and any headwinds associated with crossing the $10 billion mark. And I was wondering if you had any insight into the timeline of when you see yourself crossing that $10 billion mark, or will you try to manage under $10 billion during 2026?
Sure. We do expect to be under $9 billion in assets at closing. Still a nice runway for organic growth for several years before reaching the $10 billion mark. We are operationally ready and aware of what's required when we go over $10 billion. We had a strategic initiative back in 2023 where we spent quite a bit of time exploring that. At the time, our asset levels were in the 7-8 range, but we're also sensitive to the cost. Our focus is really on maximizing profitability rather than size, and we do have levers to pull if over the next few years we get close to that $10 billion range, so again, the deal brings us closer, but we still feel like we've got a ways to go.
Great. Thank you for that, and just one more question from me on another one on capital priorities. So your priority is to get the deal kind of closed and integrated successfully. Outside of M&A, where are your capital priorities going forward? You've been pretty active buying back shares the past few quarters, so do you expect this to continue?
No, we're always putting share buybacks on hold, at least through the date of the merger. Other things, we've also been using capital some for loss trades. We've also put those somewhat on hold as a result. That doesn't mean we wouldn't do anything, but at this point, we're conserving capital for the deal. And in some instances, the other option possibly would be, as we've earned capital back, then we'll look at potentially getting back into these activities. But we'll have to wait and see after that.
Yeah. Got it. Makes sense. Thank you for the questions. I'll step back now.
Thanks, Ashley.
Thank you for your questions. The next question comes from the line of David Feaster with Raymond James. Your line is now open.
Hey, David.
Hi. Good morning, everybody.
Morning.
First off, congrats on the deal. When I step back and kind of look at it, I mean, it's kind of a mini you, right? I mean, this is a very similar bank to y'all. You've already talked about some of the similar operating models just in terms of products and services. I guess, could you just touch on where you see the most opportunity looking forward on a combined basis? Is it mostly just allowing their bankers to leverage a larger balance sheet, maybe move upstream a little bit, or gain more wallet share with existing clients? Just kind of curious, maybe what you're more excited about coming out of this transaction?
I think it's what you alluded to, David. When we look at combining the two banks and compatible cultures and approach to business, and then the geography, of course, both organizations are very familiar with the other's geography. So with those similarities, you really get higher density, a little bigger, better, and deeper into our core markets. The expanded markets that we're moving into certainly have the benefits of an organization with a bit larger scale. So the real upside is in just what you alluded to, which is the similarities, the ability to execute, and then both companies being stronger players in our respective markets. The only other thing I would add to that is, as you've seen, Kitsap has lots of liquidity on their balance sheet.
I think there's an opportunity to deploy a higher percentage of that into loans and generate higher profitability from the combined organization.
And perfect. You just played right into my second question. I was just hoping that you could dig into maybe some of the modeling assumptions that are embedded in that EPS accretion figure. First off, I guess, what rate outlook are you assuming? And then just kind of the balance sheet optimization plans, the growth expectations, and kind of what you're planning to do with some of that excess liquidity, just given the optionality and flexibility that you guys have.
Yeah. Don, do you want to take that one?
Sure, David. As far as, I don't think we've had any specific rate assumptions necessarily. We both looked at. You can look at the analyst forecast consensus and really using some of this as a basis for Heritage with just some basic growth assumptions. And the same with really Kitsap, although we don't have analysts. We still looked at where they're at and some really basic growth assumptions on assets and net income. The margins are growing at both banks. And so we made the assumption that just like our analyst forecasts have, or the consensus is, that we consider that our. Then we'll continue to marginally increase over the next couple of years. So I think those are the main assumptions I think you're driving at as far as the cost savings.
We've kind of stated what those are, and that's obviously another big piece of that. Is there anything else on that?
And. No, maybe just, yeah, maybe thinking about the growth outlook on a combined basis. They've been kind of growing at that mid-single-digit pace. Y'all have been kind of talking about getting back towards something like that as well. Just kind of curious how you think about the organic growth outlook, the key drivers, once you're including them, and whether there's any loan pool purchases or anything else in addition to securities and organic growth that you'd be interested in.
I can take that one, Don. We didn't model anything specific when we were doing the modeling to put the companies together. But that mid-single-digit growth is very achievable in the markets, really obviously dependent on just general economic conditions. But in terms of the bank's ability to participate at the levels we have historically, very confident we can continue to do that.
Okay. Terrific. That's helpful. And just one quick one. I did notice that you mentioned retaining the Kitsap Bank brand. So are those going to remain operating under that brand, or are they going to be Heritage locations? Just kind of wanted to clarify that.
It'll be a DBA similar to how we operate on Whidbey Island. We operate with Whidbey Island Bank, Heritage Bank doing business as Whidbey Island Bank. So effectively, it's just the marketing and the signage, all of the systems and legal and kind of, if you think of the operating platforms, are all the same. But Kitsap has a great reputation, high market share, and a lot of value from our perspective in continuing to leverage that brand in those markets where they're really well-known. So that's the thought behind that.
Okay. Just wanted to make sure. Thank you.
Sure. Thanks, David.
Thank you for your question, sir. The next question comes from the line of Andrew Terrell with Stephens. Your line is now open.
Morning, Andrew.
Hey, good morning. Congrats on the deal and thanks for taking the questions. Just a couple for me that weren't already addressed. Just going back to the approaching that $10 billion threshold or getting a lot closer, do you have just an estimate or ballpark of what the Durbin impact is if you were to look at both organizations together?
Don, do you have that?
Yeah. If we looked out when this occurred, this could be, again, four or five years down the road. It could be up to close to $7 million.
Got it. Okay. And then I was curious, just on, I'm looking through just the EPS accretion and dilution and everything, and just want to make sure that I'm thinking about this the right way for the model. The baseline for the 2027 EPS accretion expectation, just there's not many consensus estimates out there yet. Are you using consensus for 2027, or is it an internal baseline that you're calculating accretion off of just as we look to square our models?
For Heritage, we were using consensus.
Okay. And then the last one, do you have? I understand you're going to be very well capitalized still going forward, but do you have a specific pro forma CET1? Or just what the CET1 impact is, just layering the deal in?
CET1?
Yeah. Let me get that for you here. Hold on a sec. I think it was, I don't know. Let's see. CET1 at close would be about mid-11s.
Mid-11s? Got it. Okay. The rest of mine were already at your.
And go ahead. I have a question on.
Yeah.
Real quick, I'm going back on your question. I think we used growth for because I don't think 2027 has much consensus out there yet. So we used consensus for 2026 and then gave a 5% growth on top of that for the modeling of the earnings initially.
Got it. Okay. Yeah. That makes sense. Yeah. I was looking in. I know most of us haven't put out 2027 yet, so I just wanted to make sure we're all thinking about the same base. But all right. Great. Well, congratulations on the deal, and thank you for taking the questions.
Thanks, Andrew.
Thank you so much for your questions. Again, if you would like to ask a question, please press star, then the number one on your telephone keypad. Our next question comes from Kelly Motta with KBW. Your line is now open.
Morning, Kelly.
Hey. Hey, good morning. Congrats on the deal. It looks exciting.
Thank you.
Most of my questions have been asked and answered at this point. But I did want to ask, you provided some good detail about the level of credit due diligence that you did. Another real important factor with deals is the people and making sure you have the right people in place. So wondering if you've done any work to identify the frontline producers that you are looking to keep and if there's any contracts or incentives in place to ensure that you remain aligned in that?
Sure. Yes. Good question. I guess I would start by saying that Olympic's CEO and president have both agreed to stay through a wind-down period post-closing. And we've been working closely over the last couple of months. And in addition to, obviously, planning for today, also a lot of discussion on how to integrate the companies and retain the employees and the customers. In addition, we have signed employment contracts with several of Kitsap Bank's key leaders, and we're excited to have them filling some very important roles here at Heritage. So we have looked at it, Kelly, and feel like we're in a really good spot to continue discussions with the rest of their team over the next few months and put a good plan together to make sure that the integration goes well for everybody.
Awesome. That's really great color there. And then maybe last question for me that's been hit a bit by others is just the liquidity that Kitsap brings. Securities will be marked, so that gives you a lot more flexibility to fund growth ahead. You've already been bringing up your loan-to-deposit ratio for you deploying the securities loss trades into loans. I'm wondering if you could refresh us on how you guys are thinking about that ratio over time, which with the additional flexibility with Kitsap. And you've always run a bit more conservatively than others, so I want to just make sure I'm thinking about it appropriately on a go-forward basis.
Sure. Don, do you want to hit on the kind of percentage of securities and, I guess, loan-to-deposit ratio at the same time?
Sure. Kelly, we've been looking to move it up. Obviously, our deposit growth this year has actually outpaced our loan growth, so it's actually come down a little bit. Their loan-to-deposit ratio is lower than ours. And so on the outset, it's going to lower that. But our goal still is to become more leveraged and to get our loan-to-deposit ratio into the mid, potentially even the high 80% range. So right now, we're in the low 80s, but I think we can easily function in the mid to high 80s, and that's kind of where we're trying to get to.
Got it. That's helpful, and then maybe last question for me. You touched on the kind of mid-single-digit loan growth that Kitsap was producing. With what Heritage brings, maybe with larger lending limits or additional capabilities, is there the potential that the combined franchise can do a bit better than that mid-single-digit growth? Or over the longer term, do you still feel like that's the appropriate outlook here, at least for the intermediate term?
Yeah. I think mid to high single digits or mid-single digits, it's more driven by the level of economic activity in the markets. And last year at Heritage, we had growth of over 10% and came into the year ahead of budget. And it was really the tariffs and some of the other uncertainty along with some payoff activity that dropped that. But I think both organizations, when you look at the market share with reasonable economic activity, can certainly produce the kind of mid-single digits or higher if we have a little stronger economic activity. So I think it's really going to be more of a factor of the economic activity. But we're certainly in a better position with the two companies combined than we are separately. So a little bit of an advantage over what we've had before.
Great. Thank you so much for all the color. I'll step back and congrats again.
Thanks, Kelly.
Thank you so much for your questions. The final question comes from the line of Don Rhodes. Your line is now open.
Hi, guys. First question I was going to ask has been touched upon a moment ago, and that is, will there be any of the senior Kitsap folks integrated into the Heritage executive team? And the second question is, what is the board of directors going to look like? Will the Kitsap board be disbanded and some people join the Heritage board, or what's the thinking in that oversight at this point in time?
Sure, well, good morning, Don, so no, there will not be any changes to the Heritage board as a result of the deal. We arrived at this arrangement deliberately through a series of conversations with Kitsap and the family. It wasn't a hotly negotiated term. It was just the natural outcome we arrived at together, so that short answer is no change to the Heritage board, but a little bit of additional color there behind it.
All right. Thank you.
Thanks, Don.
Thank you for your questions, sir. There are no further questions at this time. Mr. McDonald, I turn the call back over to you.
Okay. If there's no more questions, then we'll wrap up this call. We thank you again for your time, your support, and your interest in our ongoing performance. We look forward to announcing our Q3 earnings later in October. So with that, we'll say goodbye for this morning.