Earnings Call: Q3 2021

Oct 21, 2021

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. Followed by the number 1 on your telephone keypad. Please note today's call is being recorded. I would like to now hand the conference over to your first speaker today, Jeff Duell, CEO of Heritage Financial Corporation. Please go ahead. Thank you, Shar. Good morning, everyone, and hello to all those who might listen later. This is Jeff Duell, CEO of Heritage. Attending with me today are Don Henson, Chief Financial Officer Brian McDonald, President and Chief Operating Officer and Tony Shelpant, Chief Credit Officer. Our earnings release went out this morning pre market and hopefully you have had the opportunity to review it prior to the call. We have also posted an updated 3rd quarter investor presentation on the Investor Relations portion of our website, which can be found at heritagemanknw.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 financial performance for the Q3, while loan growth ex PPP The annualized rate of 2.6% is more modest than we had hoped to achieve. We are getting our fair share of new deals. And because of our good work with PPP, 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 continue to focus on managing expenses with good success and improving expense ratios. Note that FTE overall has declined 9% since the end of 2019. Looking forward, we expect NIE to remain relatively flat in the $37,000,000 to $38,000,000 range each quarter through 2022. Additionally, as of this month, we are ramping up the branch consolidations we talked about last quarter. Once completed, we will have reduced 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 managing our loan portfolio continues 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'll 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 Q2 of this year. Starting with net interest income, there was a decrease of $2,900,000 due mostly to a decrease in income from PPP loans and 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 1 security. While I'm on the topic of investments, I want to point out that during Q3, we transferred $245,000,000 of securities from 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 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 and the non accrual loans I previously mentioned as well as lower core loan yields And a higher percentage of excess liquidity, overnight interest earning deposits increased 21.9 percent of average earning assets compared to 15.2% in the prior quarter and 6.7% in Q3 2020. Trends of the composition of average earning assets is shown on Page 27 of our investor presentation. Removing the impact of discount accretion and PPP loans, the yields on loans decreased 26 basis points. However, 16 basis points of this increase was due to the difference in the impact of non accrual 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 of deposits, although we were very close to being as low as we were going to get. Our cost of total deposits decreased to 9 basis points in Q3, Down 1 basis points from Q2 levels. More information regarding deposit growth and cost deposits can be found on Page 25 of our investor presentation. We were very active in stock buybacks in Q3, repurchasing 2.3% of outstanding shares for a total amount of 20 point $6,000,000 Even with these buybacks, all of our regulatory capital ratios remain strongly above real capitalized thresholds. The combination of strong liquidity and capital gives us tremendous flexibility as we continue to close the bank. And you can see Page 29 of the investor presentation for more specifics 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 sales 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 2.04% compared to 2.06% in the prior quarter and 2.17% in Q3 2020. Non interest expense increased from the prior quarter due mostly to 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 $3,100,000 All of this is much lower than the reversals prior 2 quarters. Factors for the provision reversal include a decrease in non accrual loans and 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 Q3, we continued to see credit quality However, the improvement was somewhat muted by the continuing impacts of the delta variant of COVID. We also note that many of our customers remain impacted by the related labor shortages and supply chain issues. For the Q3, non accrual loans declined by 9 point $4,000,000 or 27 percent from the prior quarter. Non accrual loans are now down 55% from our December 31, 2020 levels. As of September 30, non accrual loans totaled $25,900,000 or 0.65 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 was due to pay downs and payoffs of multiple loans, all 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 2nd quarter was $293,000 which is consistent with the low levels that we experienced in the 1st 2 quarters of 2021. Other than non accrual loans, the bank has no other non performing assets. Criticized loans, those risk rated special mentioned in substandard declined by approximately 8% are $18,400,000 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 $217,200,000 Criticized loans are approximately $75,000,000 higher than December 31, 2019, which we consider to be representative of our pre pandemic are normal levels. The 2 largest components of criticized loans impacted by COVID are hotels and restaurants. Between these two industry categories, we have $88,700,000 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 3rd quarter slowed down their progress towards a pre pandemic level of performance. For more detailed information on loans in the industry categories most impacted by COVID-nineteen, please refer to Page 22 of our investor presentation. During the Q3, we experienced net charge offs of $393,000 Total charge offs were 947,000 with $689,000 attributed to one agricultural relationship that was not COVID impacted. These charge offs were partially offset by $554,000 in recoveries spread between our commercial and consumer portfolios. Through the 9 months ending September 30, Net charge offs of $60,000 remains very low when compared to our historical norms. In summary, we're pleased with the improvement in 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 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 Q3 production results, starting with our commercial lending group. For the quarter, our commercial teams closed $271,000,000 in new loan commitments, up from $151,000,000 last quarter and up from $192,000,000 closed in the Q3 of 2020. The commercial loan pipeline ended the 3rd quarter at 5 $47,000,000 up from $492,000,000 last quarter and up from $386,000,000 at the end of the Q3 of 20 We experienced an increase in new loan requests from customers and prospects during the quarter as expected due to the governors of and customer meetings. Loans excluding SBA PPP balances increased $24,000,000 during the 3rd quarter And although a modest increase is the 1st quarterly increase in loans we have seen since the Q1 of 2020. Higher loan production during the quarter was offset by increased prepays and payoffs. 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 for additional detail on the change in loans during the Consumer production, the majority of which our home equity lines of credit was $30,000,000 for the 3rd quarter, up from $23,000,000 last quarter and up from $19,000,000 in the Q3 of 2020. As a reminder, Our indirect consumer lending business in the Q1 of 2020 and the balances continue to run off, including a $22,000,000 decline Moving to interest rates. Our average 3rd quarter interest rate for new commercial loans was 3.51 percent, which is up 13 basis points from 3.38% last quarter. In addition, the average 3rd quarter rate for all new loans was 3.42 percent, down 3 basis points from 3.45 percent last quarter. The mortgage department closed $44,000,000 of new loans in the Q3 of 2021 compared to $49,000,000 closed in Refinances made up 77% of the pipeline at quarter end. Moving on to SBA PPP Forgiveness. The SPA PPP forgiveness process continues to progress smoothly. As shown on Slide 21 of the investor At quarter end, we had only 2% of round 1 PPP balances outstanding, and we were already repaid on 35% of round 2 PPP balances. In addition, to the extent we have filed claims with the SBA, these loans have been processed has been 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 over 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 Our 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 are seeing a nice upswing in our pipeline across the bank With deals coming from existing customers and to 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 opportunities The growth in our 3 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 The first question is from the line of Jeff Lulis with D. A. Davidson. You may proceed. Thank you. Good morning. Good morning, Jeff. Question on hi, Jeff. For Don, thanks for the Slide 27. Just wanted to confirm that core NIM, does that exclude I'm assuming it does not exclude PPP impact and interest recoveries? Jeff, no, it does not. So again, You can we have in the back of the earnings release, we have a supplemental schedule kind of for the non GAAP piece that shows the dollar amount of PPP. And so you can get that information there and see what the actual yields were on PPP. So if you Okay. And so the interest recoveries, were there any I know that one came back 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 18 basis points impact in Q2 and it was down to 2 basis points impact. So again, as I mentioned that the yields were down 21 basis points, well, 16 basis points had to do with the kind of quarter over quarter Change in the recoveries on non accrual loans. Okay. Great. Thanks. And just I guess your thoughts on the core margin, Don. I don't know if I missed that, but just where we kind of settle in here. Yes. I think it's going to continue to fall. Again, we're getting PPP loans themselves had Another big impact, I think it was $8,000,000 in Q3 and that's going to, I think, 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 our goal is to continue to grow loans And investments as needed to offset some of the decline in PPP, but it's going to fall some more Into Q4, possibly into Q1 also, but we are looking at the flatten out over sometime over the next couple of Got it. And Brian, On Slide 19, you've got the payoffs and prepays in the Q3. How does that number compare? I think you just said It was up from Q2, but do you have the combined number of what that figure was? Yes. Q2 combined of prepays and payoffs was about $168,000,000 And so if you look back to Q1, it And on a monthly basis, it was mid-forty million dollars range and then mid-fifty million dollars range in Q2 and then Q3 got up over $60,000,000 I think it comes out at about $62,000,000 average per month. A lot of that, Jeff, is the economic activity in the region. We're seeing more Sales of buildings and businesses similar to what we were seeing pre pandemic. Got you. Okay. And last one for Jeff. Obviously, the merger activity in the area and Buyers, potential buyers, maybe that pool is shrinking. Just revisiting the M and A topic for you As you see those 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 came out last This week was a surprise, I think 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 our conversations going into 2022, but I think Maybe for us, the landscape has improved our situation from the standpoint of being a potential acquirer, Because there's 2 potential competitors that are busy. Glacier is busy And First Interstate is busy. So I 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. Appreciate it. Thank you. Thank you. Thank you, Mr. Rulis. The next question is from the line of Matthew Clark with Piper Sandler. You may proceed. Sorry, first one for me, just around the higher payoff It sounds like some of its businesses selling the Buildings, but I guess how much of the incremental pressure is coming from some other banks that are willing to do longer term Great stuff. And are you having to compete at all? Are you just letting it go? Brian, you want to take that one? Sure. We are continuing to get in addition to the building sales, business sales, We're also continuing to get paid off on some of our credits where customers are looking for refinances where The terms we're offering aren't quite as aggressive as the competition. Now I wouldn't say that's hugely outsized to what it was a couple of years ago where we were Experiencing the same sort of thing. We see that a lot on maybe it's A multifamily property or a non owner of property where somebody is looking to refinance and take cash out of it, that sort of thing. We're not Always as competitive as other players in some of those markets. So there is an uptick in activity there What we would have a year ago, but I wouldn't consider it oversized. The biggest A couple of big changes versus a year ago. If you look at Slide 18 of the investor presentation, that C and I utilization rate still Your presentation, that C and I utilization rate still remains quite low. So even on the new C and I deals that we're booking, Oftentimes, there is a line and sometimes a significant line, but it's very likely it also has a very low or even a zero balance. So 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 in categories of loans during the quarter, Slide 3 of the The earnings release had a table on it, but we saw good growth in owner occupied, number 1. We're still seeing that and we have a really nice amount of Owner occupied real estate in the pipeline, the commercial was really flat and then some growth in perm non owner, a little bit In mortgage and then of course some consumer declines. And so that's really what I see is just still some soft demand on that Existing primarily around our existing customer base on commercial non real estate type requests. Okay. And then the increase you're seeing in commitments within commercial, C and I and CRE owner occupied, what are the types of underlying Properties, you're seeing the biggest uptick in here more recently? Yes. 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 pretty broad Base of commercial businesses, many are busy and looking for additional space to expand or acquire The properties they're currently leasing, we have a big pipeline on the SBA 504 side, several multiples of what we would normally have. Of course, of what we would normally have. Of course, we're taking the 50% bank Financial portion of 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 or location of Seattle Bellevue, but also strong up and down the footprint. Okay, great. 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 the PPP and the contribution there, I think it's like $0.80 a share this year roughly. And then another $0.55 kind of benefit from negative provisioning. So, 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. If not, maybe do a little better. And then just on the high single digit loan growth, You mentioned, Jeff, the timing at which you think you can restore that? Yes. 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. I think that we've had our fits and starts over this summer, Recalling that the governors allowed us to open up in early July and then when everybody realized that they were Free to move around. Everyone went on vacation in August, including most of our employees. So that's the fits and starts over the summer. But I Once everyone hunkered down in September, we've started to see a nice upswing in Not just the pipeline, but Tony, Brian and I make up the executive loan committee where we see the largest deals or the largest relationship Activity and we've all three of us been remarking to each other how much more activity there's been in the last couple of months than we've seen in a Which is just kind of intuitively showing that we're headed in the right direction. But I think, Brian may have Some anecdotal feedback for you on this, but I think we're just going to see it gradually continue to increase. And if we're Fortunate and it plays out the way we hope it will, that we'll start getting closer to more historical levels of production probably early in the New Year. Brian, anything to add to that? Just maybe tying into a couple of the specifics. We ended the quarter with a pipeline of $547,000,000 up from $492,000,000 and more loan closings during the quarter And Q2. So we're heading 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 $600,000,000 and then the loan closings from where they were last quarter, which was around $90,000,000 average a month To something a bit over $100,000,000 Again, it depends on payoffs. So we're heading in the right direction, and that's where We're all focused and our teams are focused. And by focused, I mean, just trying to be as active out calling as we can be to turf up as many Opportunities and get in front of our clients and make sure that we're just providing that extra touch To try and get additional opportunities. So if we can do that, we're up in the High single digits, if we can get the pipeline up another $50,000,000 $60,000,000 and bump the closings On a monthly basis. Got it. Thank you. Thanks, Matt. Thank you, Mr. Clark. There are no additional questions waiting in the queue. I would now like to pass the conference back to Jeff. Well, Shar, thank you very much for moderating for us, and thank you to everyone who Called in, we appreciate your interest in our story and we'll see some of you or We'll visually see some of you 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 Thank you all and enjoy the rest of your day.