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Heritage Financial Corporation (HFWA 1.28%)
Q4Â 2019 Earnings Call
Jan 23, 2020, 2:00 p.m. ET
Contents:
- Prepared Remarks
- Questions and Answers
- Call Participants
Prepared Remarks:
Operator
Ladies and gentlemen, thank you for standing by and welcome to the Heritage Financial Fourth Quarter and Year-End Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] And as a reminder, this conference is being recorded.
I would now like to turn the conference over to our host, Mr. Jeff Deuel. Please go ahead, sir.
Jeff Deuel -- President, Chief Executive Officer
Thank you, Kingston. Welcome to all who called in and those who may listen-in later, this is Jeff Deuel, Chief Executive Officer of Heritage. Attending with me are Don Hinson, Chief Financial Officer; and Bryan McDonald, Chief Operating Officer.
Our earnings press release went out this morning pre-market, and hopefully you have had an opportunity to review it prior to this call. Please refer to the forward-looking statements in that press release.
As for the quarter, we are pleased with our progress as we continue to build our franchise and generate attractive financial results for our shareholders. We've made good progress building on our metro strategy in the Seattle and Bellevue and Portland markets.
We have seen the initial benefits of the two acquisitions we completed in 2018, and the team we added in early 2019. Together, the Seattle, Bellevue and Portland markets still represent significant opportunities for Heritage, and we believe we have positioned ourselves well to continue to execute in those markets. We also see good performance in our traditional markets. We saw strong loan production in 2019 with healthy loan pipeline growth and strong originations. However, our net loan growth continued to be muted by loan payoffs. We believe we have laid down a good foundation for 2020, which will allow us to continue the positive momentum from 2019.
We believe there is additional production capacity embedded in our existing platform, which will help us overcome the higher than historical level of payoffs that we've been experiencing for the past couple of years. While we continue to see deposit rate competition, our loan-to-deposit ratio of 82%, allows us to carefully manage pricing competition.
We continue to focus on protecting our core deposit franchise, which provides us with a strong foundation, and it is one of our key strengths.
Don Hinson, will now take a few minutes to cover our financial statement results, including color on our core operating metrics.
Don Hinson -- Executive Vice President, Chief Financial Officer
Thank you, Jeff. I'm going to start with a quick overview of earnings before heading into more detail on our balance sheet, credit quality, income statement and capital management. Our reported diluted earnings per share for Q4 was $0.47, which is down $0.01 from $0.48 in Q3. The decrease in earnings from Q3 was due mostly to a combination of a decrease in the net interest margin, and an increase in the provision for loan losses, partially offset by higher swap fees and lower non-interest expense.
Although our reported ROA decreased 9 basis points from the prior quarter, our pre-tax pre-provision ROA decreased only 3 basis points. Moving onto the balance sheet, gross loans grew $36.5 million or 3.9% on an annualized basis in Q4, and increased about $114 million or 3.1% for the year.
Brian McDonald will further discuss loan production in a few minutes.
Although, overall deposit growth was muted in Q4, noninterest-bearing deposits increased $17 million, which was 84% of the deposit growth in Q4. For the year, noninterest-bearing deposits increased $84 million or 6.2%, which was 56% of the deposit growth for the year.
Regarding credit quality, we experienced additional increases in non-accrual loans in Q4, due mostly to a $4.7 million ag relationship that was put on nonaccrual status during the quarter. Net charge-offs increased to 20 basis points for Q4, due mostly to a $963,000 charge-off on a large agricultural loan relationship that was put on nonaccrual status in Q3.
Net charge-offs for 2019 were 9 basis points, up from 6 basis points in 2018. Although, overall problem loans and charge-offs are at elevated levels, with the exception of identified ag credits, we do not see any specific negative trends in the portfolio. Net interest margin decreased 19 basis points in Q4, due mostly to a 16 basis point decrease in the loan portfolio yield. Approximately 4 basis points of the decrease in NIM was due to a change in the mix of earning assets from the prior quarter. Although most of the decrease in the loan portfolio yield was due to the rate environment, a portion of the decrease was due to non-accrual, non-accrual loan activity, which accounted for 2 basis points, and lower discount accretion, which accounted for 1 basis point, as well as the significant turnover in the loan portfolio in the form of originations and pay-offs, which Bryan McDonald will discuss in a few minutes.
The cost of total deposits increased 1 basis point to 39 basis points in Q4. We believe we have hit the inflection point in the cost of deposits, and that we should start see gradual decreases in these costs in future quarters.
However, due to the spread between rates of new loans and existing loans, we do expect continuing pressure on net interest margin in the near term.
Noninterest expense decreased $722,000 from the prior quarter. The improvement was driven mostly by lower business and use taxes from the prior quarter, due to the assessment we incurred in Q3.
As mentioned in the earnings release, we were again able to use a credit for FDIC premiums in Q4, and we still have $518,000 in credits, which will be used in future quarters if the deposit insurance fund remains at a certain level. As a result of our overall lower cost and higher asset levels, we saw a nice improvement in our overhead ratio, which moved down to 2.57% in Q4, from 2.69% in Q3. We do expect higher occupancy and equipment expense in future quarters as we occupied a new operation center in Q4, which will provide us space to grow.
The impact -- the expense impact of the new office center is about $150,000 to $200,000 per quarter from the Q4, 2019 levels. Some of these costs will be offset by lower future costs from exiting other lease basis, as well as realizing expected gains from sale of owned buildings we are also exiting.
And finally, moving on to capital management, our tangible common equity ratio at December 31 was 10.4%, unchanged from the level at the end of Q3. We have grown our tangible book value per share to $15.07, 1% [Phonetic] increase from 13.54% at the end of 2018.
As a result of our strong capital position and earnings performance, we increased our regular dividend to $0.20 this quarter, up from $0.19 last quarter.
As a reminder, although we did not buyback any stock in Q4, we have approximately 640,000 shares remaining in our current stock repurchase plan. We will continue to monitor quarterly dividend levels and potential share repurchases, but also like having the flexibility if and when a potential acquisition opportunity arises.
Bryan McDonald will now have an update on loan production.
Bryan McDonald -- Executive Vice President, Chief Operating Officer
Thanks, Don. I'm going to provide detail on our fourth quarter production results by area, starting with our commercial lending group. In the fourth quarter, our commercial teams closed $306 million in new loan commitments, very similar to the volume closed in each of the past two quarters. New production during the fourth quarter was centered in Seattle and Belleview at $79 million, Tacoma at $65 million, and Portland at $54 million.
For the full year, new commercial loans totaled $1.05 billion, which is an increase of $311 million or 42% compared to 2018. Commercial team loan pipelines ended the fourth quarter at $390 million, down 11% compared to the third quarter, but remain up 15% compared to the fourth quarter of 2018.
The largest pipelines were in our Seattle and Bellevue teams, which ended the quarter with a pipeline of $153 million. Our greater Portland teams, which ended the quarter with the pipeline of $72 million, and our greater Tacoma teams, which ended the quarter with the pipeline of $70 million.
Gross loans increased only $36.5 million during the fourth quarter, or 3% annualized rate due to high levels of prepayment and payoff activity. Loan prepayments and payoffs during the quarter totaled $202 million versus $169 million in the 3rd quarter, and $160 million in the second quarter of 2019.
Payoffs and prepayment activity in the fourth quarter was caused by a higher level of business to real estate sales, customers using cash to pay off debt and client's paying off loans due to our active portfolio management efforts.
SBA 7(a) production in the fourth quarter included 9 loans for $10.6 million, and the pipeline ended the quarter at $5.1 million. This compares to last quarter, where we closed 15 loans of $4.9 million, and the pipeline ended the quarter at $14.8 million.
Consumer production during the fourth quarter was $49 million, down from $61 million in the third quarter, and equal to the $49 million we closed in the fourth quarter of 2018.
Moving on to interest rates. Our average fourth quarter interest rate for new commercial loans was 4.43%, a decrease of 23 basis points, from 4.66% last quarter. In addition, the average fourth quarter rate for all new loans was 4.45%, dropping 42 basis points from 4.87% last quarter.
The mortgage department closed $52 million of new loans in the fourth quarter of 2019, compared to $47 million closed last quarter, and $28 million closed in the fourth quarter of 2018. The mortgage pipeline ended the quarter at $15 million versus $39 million last quarter, and $23 million in the fourth quarter of 2018.
I will now turn the call back to Jeff, for some general observations.
Jeff Deuel -- President, Chief Executive Officer
Thank you, Bryan. We continue to benefit from the positive economic environment here in the Pacific Northwest with strong stable valuations for commercial real estate and single-family properties. In spite of the positive economic environment in the region we remain cautious about concentration levels, and are operating at levels that provide us flexibility to take advantage of high quality loan opportunities, while still being able to maintain discipline focusing on loan quality and yield.
We have strong teams in all the markets we serve, and we will continue to execute in those markets to generate future growth. While we were distracted with two M&A transactions in 2018, several internal projects were put on hold during 2019. The team restarted those projects and have worked diligently to update, upgrade a variety of product delivery platforms that are enabling us to launch a new treasury management platform from our -- for our commercial customers in the first quarter of 2020.
We expect that new platform to enhance the customer experience for existing customers and also it will allow us to pursue new customers with more complex cash management needs. We continue to benefit from our balance sheet liquidity and the high quality and granularity of our deposit base.
Cost of deposits have been stable for the past three quarters, and the overall costs are still relatively low. We continue to manage our capital position to support our planned organic growth, as well as positioning the bank, so we can respond to M&A activity.
Before we go on to questions, I'd like to make few comments about credit quality. We continue to actively manage the loan portfolio like we have always done. Unfortunately, the effort is not always pretty. However, these efforts tend to play out in a positive way through our long-term credit metrics. For example, in the second quarter of 2019, we reported elevated potential problem loans, with the addition of seven new loans totaling $27 million. Two quarters later, three of those seven loans totaling almost $11 million have paid off, and we do not expect to see significant losses from the remaining loans in that pool.
The $20 million non-accrual ag loan we reported last quarter, continues to be closely managed. And after allowing time for the harvest results, we determined that charge-off was appropriate given the circumstances. We have adequate collateral coverage based on updated valuations and we do not expect significant losses from this one-off.
The newest loan to go on non-accrual is also fully collateralized ag loan, one that we have been working through the credit process for several quarters. We obviously see weakness, but we do not see a substantial loss. The only specific area of concern in our portfolio right now relates to the ag segment, which you know is less than 3% of our overall portfolio. And in this segment, we have been reporting on for several quarters.
Lastly, I would point out that as you watch us actively manage the portfolio, you will see our loans either move up or out. But over time, our actual credit losses or costs continue to be pretty loan.
And as I said earlier, we are pleased with our performance to-date. We are grateful to our team for our improved production numbers. And we can point we are well positioned for the future with good growth opportunities in our newer metro markets, as well as in our traditional markets in Washington and Oregon.
That's the conclusion of our prepared comments. So, Kingston, we're ready to open up the call now for, and welcome any questions.
Questions and Answers:
Operator
Certainly. [Operator Instructions] And we do have something from the line of Jeffrey Rulis. Please go ahead.
Jeff Deuel -- President, Chief Executive Officer
How are you Jeff?
Jeffrey Rulis -- D.A. Davidson & Co.
Hi, fine. Question on the -- just to get some color on the loan growth outlook, in '19 you mentioned the payoff activity, maybe there is some risk management, there always is, as you kind of alluded to, Jeff. But looking at '20 and kind of what could play out or what could change? I guess your expectations for growth on a net basis of 3% in 2019, but there was some pieces there that may -- payoff activity being one that was a little elevated. What thoughts on '20 going?
Jeff Deuel -- President, Chief Executive Officer
Yes. Happy to make some comments on that and Bryan McDonald may want to tag on to it. But we see good momentum in our pipeline. We also believe that there is untapped potential in our platform, overall. I think that the best way for us to put is, we're looking for loan and deposit growth in that mid-single digit range in 2020. And Jeff, that's based on two things. One, it assumes that we're not changing our risk profile, which is something that we were intending to do. And we -- based on what we're seeing in the last couple of quarters, we're not expecting that the higher level of payoffs is going to necessarily trend away from us.
In fact, based on what Bryan reported, you could see in the fourth quarter it actually went up over other quarters. So, I think that mid-single digit range is a good place for us to be.
Jeffrey Rulis -- D.A. Davidson & Co.
[Speech Overlap]
Jeff Deuel -- President, Chief Executive Officer
I'm sorry. I just thought Bryan had something to add. But you can go ahead.
Jeffrey Rulis -- D.A. Davidson & Co.
Okay. Sorry about that. And on the credit side, the ag relationships, I forget, what -- are they related or a similar strain, kind of a systemic that is driven both to kind of non-accrual?
Jeff Deuel -- President, Chief Executive Officer
No. And we spent, as you probably recall, Jeff, we spent a lot of time talking about the -- one that went on non-accrual last quarter, it's Tree Fruit. And it's -- the weakness is based on many factors, pricing, whether transitional issues from one generation to another, etc. So, we still feel fairly comfortable with our position with that particular loan, particularly in fact -- particularly in light of the fact that since we last, at our quarterly call, we had the valuations were done for the real estate, and the equipment and the pricing or the values are holding.
So, we have this odd circumstance where we have a loan on non-accrual. We've taken a charge-off on it. But we still believe that we're -- based on the information we have now, we're fully collateralized.
The other one, the newer one is one that we've been working on for many quarters. And it's been working its way through the process. It's a hay producer. And the circumstance there is that there is an abundance of hay. So, there is a good amount of inventory in that relationship. But it's moving slowly. So, there is the weakness.
Jeffrey Rulis -- D.A. Davidson & Co.
Okay, thanks for that. And maybe last one on -- Jeff, just. M&A, obviously you didn't complete any whole bank deals in '19. And I know the bank's culture is not to force activity, but I guess if you add your preferences, would you be kind of lending team focused or whole bank focused in '20 if you've --? And maybe just broadly speaking, overall M&A discussions that you've had, what the pulse of that is?
Jeff Deuel -- President, Chief Executive Officer
Yes. I think we're actually sitting in a good position. From where we sit now with regard to M&A, from the standpoint that we're clearly past the integration at work that goes -- went around the two transactions we did in 2018. As I mentioned in the prepared remarks, we've been working on getting our systems in order and upgraded and updated, which is essentially done. The rollout is the next big step. And that will keep us occupied while we wait for opportunities. But I believe that our team is ready to roll if something presents itself.
We are very interested in further developing our footprint along the I-5 Corridor from the Canadian border to the southern border of Oregon. Conversations were non-existent for the first half of last year. But toward the end of the year, we started having not just inform casual updates, but more conversations with a couple of potential candidates. But as you mentioned, we don't rush these things. They have to present themselves when they're ready. But we feel comfortable that if M&A presents itself in the new year, that we're ready to pursue it.
Jeffrey Rulis -- D.A. Davidson & Co.
Great. Thanks, Jeff.
Operator
Thank you. And next we will go to the line of Gordon McGuire. Please go ahead.
Jeff Deuel -- President, Chief Executive Officer
Good morning, Gordon.
Gordon McGuire -- Stephens Inc.
Rehash a little bit your comments on the mid-single digit loan growth. I guess last quarter you had mentioned, low-to-mid single-digit. And I'm wondering if this untapped potential that you mentioned is the driver going from low-to-mid to mid, and whether that's a new development or something that gives you a little bit more optimism relative to three months ago? And if you could just elaborate on what that would be?
Jeff Deuel -- President, Chief Executive Officer
I think that we've had the chance to watch the combined organization operate for several quarters now. So, I think we have a better flow for the ebbs and flows of deposits and loans. I think we've also had the time to really analyze the production-to-date across the footprint and compare that to the potential of the particular markets we're in, the teams that we have. And I think we've put it all together and I think that we are in a, maybe in a better position now to move forward and mine that additional capacity.
I think the other thing I would add to it is, it just takes a while for three organizations to come together and work like a fine-tuned machine. And I'm not sure we're quite fine-tuned yet, but I think we're further along the curve from that standpoint. So, we're better organized internally.
Bryan, you want to add to that?
Bryan McDonald -- Executive Vice President, Chief Operating Officer
Yes, I was just going to add, Gordon, when you look at the difference between mid-single digit and that 6%, 7% 8%, it's a pretty moderate difference in terms of production. So, if you look at the Q4 numbers, it's about $102 million a month is the new production we did in the fourth quarter. And to get it closer to that 6% range with the same level of payoffs, it's more like a $108 million. So it's $6 million difference, it's a very moderate increase relative to the total amount of production, obviously the few million dollars of net, if it drops through, it really drives that, is what drives the growth rate. And so after watching plus $100 million of production in the last three quarters of last year and the work our team is doing to try and drive that pipeline up, that's really what we're shooting for is another $6 million a month versus what we did in the fourth quarter.
Gordon McGuire -- Stephens Inc.
Good. Don, I was hoping you could help us out with just the run rates on the fees and the expense levels. I guess starting with fees, the swap income was really strong this quarter. Is that something you feel is sustainable?
Don Hinson -- Executive Vice President, Chief Financial Officer
It was -- it's higher than usual. And we're not, I don't expect to see that every quarter. If you go back again to the year, it was $1.2 million. I think that -- I'd like to see that higher than that overall for the year and in 2020, but it's not going to be at the $900,000 a quarter that we're -- we're not expecting now to see that much. Improved year-over-year, but not from Q4 numbers.
Gordon McGuire -- Stephens Inc.
Got it. So, it is tracking better than the previous run rate before the fourth quarter?
Don Hinson -- Executive Vice President, Chief Financial Officer
Well, yes. It's kind of early in the year, but that's what's our expectation.
Gordon McGuire -- Stephens Inc.
Got it. And then the expenses, I guess, it looked like there was an FDIC credit this quarter, and marketing was a little bit unusually low relative to where that's been in the past. Could you just kind of point us to a baseline to think about for the first quarter?
Don Hinson -- Executive Vice President, Chief Financial Officer
I'll give you some directional feedback here. The -- you're right, the FDIC premium is down. If things work out as we think they will, we'll be able to use the credit again in Q1 and partly in Q2. As you can -- if you look at our financial, it's usually -- the FDIC premium is usually between $350,000 and $400,000 a quarter. And again, that's going to probably run out midway through the second quarter, since we have like $500,000 some left on that.
I will also say that Q1, we just tend to see a bump in expenses, and then Q4 is always our lowest. And usually it's in the areas of like marketing. And, of course, things like payroll taxes always pop up the first part, insurance pops up usually the first part, first quarter. So, like, I looked at last year, and our expenses, core expenses went up $600,000 from Q4 '18 to Q1 '19.
In addition, as I mentioned, we're in a new facility. As far as operations go, that's going to raise up some cost there. And we have the, as Jeff mentioned, the new treasury management system that we are implementing this year. And that's going to be about, a cost about $1 million this year over what we've been spending. So, I would say, take that into consideration as you look at the expenses for this year. And that should help you out on that.
Gordon McGuire -- Stephens Inc.
Got it. And the cost of the treasury platform, is that kind of ratably throughout the year it builds or how should [Speech Overlap]
Don Hinson -- Executive Vice President, Chief Financial Officer
I would say the first three quarters it will be when it's mostly implemented. And how much per quarter will depend on, it's kind of based on the number of customers that we're converting over at that time. So, I can't really give you like a real ratable each quarter. But it should happen over the first three quarters.
Jeff Deuel -- President, Chief Executive Officer
And, ultimately, Gordon, that will go away. It's really a support function for us as we transition our customers from the current system to the new system.
Gordon McGuire -- Stephens Inc.
Got it. Thanks for clarifying that. I'll step out of the queue. Thank you.
Jeff Deuel -- President, Chief Executive Officer
Thank you.
Operator
Thank you. And next we will go to the line of Matthew Clark. Please go ahead.
Jeff Deuel -- President, Chief Executive Officer
Good morning, Matt.
Matthew Clark -- Piper Jaffray
Hey, good morning. I may have missed it, but the amount of payoffs in the quarter?
Bryan McDonald -- Executive Vice President, Chief Operating Officer
Yes, Matt, this is Bryan. It was $202 million was the prepayments during the quarter, up from $169 million in the third quarter, and $160 million in the second quarter.
Matthew Clark -- Piper Jaffray
Okay. And then just given your comments on expenses this year, any thoughts around the overhead ratio relative to last year?
Jeff Deuel -- President, Chief Executive Officer
Our goals are, again, continued improvement year-over-year. And, again, a lot of our expenses are seasonal. So, it's not, again, from like Q4 to Q1 improvement, so much as 2019-2020, we expect improvement in that even with some of these other initiatives we have going on. Of course, with the initiatives, it won't be as improvement as, if we hadn't had implementation of the treasury management system. Obviously, that's going to slow down the improvement, but we still expect to see some improvement.
Matthew Clark -- Piper Jaffray
Okay. And then the percent of the ag portfolio that's classified at year-end?
Bryan McDonald -- Executive Vice President, Chief Operating Officer
44% of the ag portfolio.
Matthew Clark -- Piper Jaffray
Okay. And then just on the margin outlook, it sounds like some additional pressure here in the near term. Any -- I think you had guided in the past, down 5% to 10%, came in a little bit more than that. But just curious on your thoughts on the margin outlook and when that might be able to stabilize, if at all, given the pressure on new business?
Don Hinson -- Executive Vice President, Chief Financial Officer
Well, I expect it to come down again, and similar expectations this fall, this next quarter, just by looking at what's going on, the loans that are going on and what's coming off. I think, again, I think our deposit costs were stable -- are going to stabilize, if not start coming down. Again, we don't have a lot of room to come down, so. But I do think they'll start coming down either Q1 or Q2. But I do think we're going to see pressure because of the loan portfolio. Even without any further rate cuts, the yield curve is still not too great for putting on new loans. In fact, in the last few days, it's gotten worse. So, that's where the pressure is going to be is on the loan side.
Again, it turned out to be, as I mentioned in my comments in the earnings release, I think it came down more than expected in Q4 due to also some of -- the mix of earning assets played a part in that, in addition to some additional non-accruals.
So, those are all factors that we -- it's hard to predict exactly what will happen and how that will impact the margin. But I do expect it to come down again in Q1.
Matthew Clark -- Piper Jaffray
Okay. And then just any update on CECL Day 1 impact?
Don Hinson -- Executive Vice President, Chief Financial Officer
We're still working on our model. We're basically going over. We have a model set up and just making sure that we're getting all of our assumptions, such as prepayment speeds and reversions norms, or historicals, those type of things are still tweaking. So, we don't really have a number right now. We'll be putting an estimate in our 10-K at the end of February. But it's not -- it's not going to be a huge impact. But, obviously, we'll have some.
Matthew Clark -- Piper Jaffray
Okay. Thank you, guys.
Jeff Deuel -- President, Chief Executive Officer
Thanks, Matt.
Operator
Thank you. And we have no further questions in queue. Please go ahead.
Jeff Deuel -- President, Chief Executive Officer
Okay. Well, thank you. If there's no more questions then we're ready to wrap up the quarter's earnings call, and we thank you all for your time, your support, your interest in our ongoing performance as an organization. And we look forward to seeing several of you over the coming week of the Investor Events that we have. Thank you and goodbye.
Operator
[Operator Closing Remarks]
Duration: 31 minutes
Call participants:
Jeff Deuel -- President, Chief Executive Officer
Don Hinson -- Executive Vice President, Chief Financial Officer
Bryan McDonald -- Executive Vice President, Chief Operating Officer
Jeffrey Rulis -- D.A. Davidson & Co.
Gordon McGuire -- Stephens Inc.
Matthew Clark -- Piper Jaffray
