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Heritage Financial Corporation (NASDAQ:HFWA)
Q3 2021 Earnings Call
Oct 21, 2021, 2:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning. Thank you for standing by, and welcome to the Heritage Financial Corporation Third Quarter 2021 Earnings Call. [Operator Instructions]

I would like to now hand the conference over to your first speaker today, Jeff Deuel, CEO of Heritage Financial Corporation. Please go ahead.

Jeffrey J. Deuel -- Chief Executive Officer

Thank you, Char. Good morning, everyone, and hello to all those who may listen later. This is Jeff Deuel, CEO of Heritage. Attending with me today are Don Hinson, Chief Financial Officer; Bryan McDonald, President and Chief Operating Officer; and Tony Chalfant, 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 third quarter investor presentation on the Investor Relations portion of our website, which can be found at heritagebanknw.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 third quarter. While loan growth ex-PPP at an annualized rate of 2.6% 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 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 through the balance of the year and into 2022.

We continued 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 million to $38 million range each quarter through 2022. Additionally, as of this month, we are wrapping 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 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'll now move on to Don who will take a few minutes to cover our financial results.

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

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 pay-off 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 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 purchases as held to maturity so that are held to maturity portfolio is 29% of total investments as at 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% of average earning assets compared to 15.2% in the prior quarter and 6.7% in Q3 2020. Trends in 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. Bryan 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 were going to get. Our cost of total deposits decreased 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 dollar amount of $20.6 million. Even with these buybacks, all of our regulatory capital ratios remained strongly above well capitalized 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.

Non-interest income saw a slight decrease, primarily due to lower mortgage loan sale gains, being 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, our 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 a reversal of provision for credit losses in the amount of $3.1 million, although this is much lower than the reversals in the prior two quarters. Factors for the provision reversal include the 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.

Tony Chalfant -- Executive Vice President and Chief Credit Officer

Thank you, Don. In the third quarter, we continue to see credit quality improve across our loan portfolio. 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 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 30, non-accrual loans totaled $25.9 million or 0.65% of total loans. $7 million of the reduction was a result of returning an 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 was due to pay-downs and pay-offs 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 second quarter was $293,000, which is consistent with the low levels that we experienced in the first two quarters of 2021. Other than non-accrual loans, the bank has no other non-performing assets.

Criticized loans, those risk-rated, special mentioned and substandard, declined by approximately 8% or $18.4 million since the end of the second quarter and 25% from December 31 of 2020. While improving, criticized loans remain elevated when compared to pre-pandemic levels. At $217.2 million, criticized loans are approximately $75 million higher than December 31 of 2019, which we consider to be representative of our pre-pandemic or normal levels. The two largest components of criticized loans impacted by COVID are hotels and restaurants. Between 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 toward a pre-pandemic level of performance. For more detailed information on loans in the industry categories most impacted by COVID-19, please refer to Page 22 of our investor presentation.

During the third quarter, 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 nine 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 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 cases subside.

I'll now turn the call over to Bryan who will provide an update on loan production and our SBA PPP activity.

Bryan D. McDonald -- Executive Vice President

Thanks, Tony. I'm going to provide detail on our third quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $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 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, it 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 prepays and pay-offs. This in conjunction with the run-off 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 in the investor presentation 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 3.51%, which is up 13 basis points from 3.38% last quarter. In addition, the average third quarter rate for all new loans was 3.42%, down 3 basis points from 3.45% last quarter. The mortgage department closed $44 million of new loans in the third quarter of 2021 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% of the pipeline at quarter end.

Moving on to SBA PPP forgiveness. The SBA PPP forgiveness process continues to progress smoothly. As shown on Slide 21 of the investor presentation, at quarter end, we had only 2% of Round 1 PPP balances outstanding, and we were already repaid on 35% of Round 2 of PPP balances. 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.

Jeffrey J. Deuel -- Chief Executive Officer

Thank you, Bryan. 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 reengagement, 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 into 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 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 Char, we're ready to open up the line for questions from people on the call if we could.

Questions and Answers:

Operator

Absolutely. [Operator Instructions] The first question is from the line of Jeff Rulis with D.A. Davidson. You may proceed.

Jeffrey A. Rulis -- D.A. Davidson & Co. -- Analyst

Thank you. Good morning. I have a question on...

Jeffrey J. Deuel -- Chief Executive Officer

Good morning, Jeff.

Jeffrey A. Rulis -- D.A. Davidson & Co. -- Analyst

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?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

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 want to back that.

Jeffrey A. Rulis -- D.A. Davidson & Co. -- Analyst

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?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Yeah. So 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, the yields were down 21 basis points. 16 basis points had to do with the kind of a quarter-over-quarter change in the recoveries on non-accrual loans.

Jeffrey A. Rulis -- D.A. Davidson & Co. -- Analyst

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 are we kind of settling here?

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Yeah. It's going to -- I think it's going to continue to fall. Again, we're getting -- PPP loans themselves have another big impact. I think it was $8 million 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 it to the flatten out over -- some time over the next couple of quarters.

Jeffrey A. Rulis -- D.A. Davidson & Co. -- Analyst

Got it. And Bryan, on Slide 19 you've got the pay-offs and prepays 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 of what that figure was?

Bryan D. McDonald -- Executive Vice President

Yeah. Q2 combined of prepays and pay-offs 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 mid-$50 million range in Q2 and then Q3 got up over $60 million. I think it comes out about $62 million average per month. And 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.

Jeffrey A. Rulis -- D.A. Davidson & Co. -- Analyst

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&A topic for you as you see those conversations anything to kind of update or just your thoughts on how the landscape is evolving?

Jeffrey J. Deuel -- Chief Executive Officer

Well, I guess, it's an understatement to say that the announcement that came out last week was a surprise. I think for many people that does change the landscape here. It does show there is 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 is two 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.

Jeffrey A. Rulis -- D.A. Davidson & Co. -- Analyst

Okay. Appreciate it. Thank you.

Jeffrey J. Deuel -- Chief Executive Officer

Thank you.

Operator

Thank you, Mr. Rulis. The next question is from the line of Matthew Clark with Piper Sandler. You may proceed.

Matthew T. Clark -- Piper Sandler -- Analyst

Hey, good morning. First one for me just around the higher pay-off activity. It sounds like some of it's businesses selling, selling the buildings, but I guess, how much of kind of the incremental pressure is coming from some other banks that are willing to do longer term fixed rate stuff? And are you having to compete at all or are you just letting it go?

Jeffrey J. Deuel -- Chief Executive Officer

Bryan, you want to take that one?

Bryan D. McDonald -- Executive Vice President

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 are quite as aggressive as the competition. Matt, 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 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 a uptick in activity there versus 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 that of the investor presentation, that C&I utilization rate still remains quite low. So even on the new C&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 earnings release had a table on it, 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 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 as just still some soft demand on that exists, primarily around our existing customer base on commercial non-real estate type request.

Matthew T. Clark -- Piper Sandler -- Analyst

Okay. And then the increase you're seeing in commitments within commercial C&I and CRE, owner-occupied, non-owner, what are the types of underlying properties you're seeing the biggest uptick in here more recently?

Bryan D. McDonald -- Executive Vice President

Yeah. 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, we're taking the 50% bank finance portion as 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.

Matthew T. Clark -- Piper Sandler -- Analyst

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 can you just -- you may have said it in your prepared comments, my 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, I think you mentioned, Jeff, the timing at which you think you can restore that?

Jeffrey J. Deuel -- Chief Executive Officer

Yeah, Matt, good question. And Bryan, 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 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 think once everyone hunkered down in September, we've started to see a nice upswing in not just the pipeline, but Tony, Bryan 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 has 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 just kind of intuitively showing that we're heading the right direction. But I think, Bryan, 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 then we'll start getting closer to more historical levels of production probably early in the New Year.

Bryan, anything to add to that?

Bryan D. McDonald -- Executive Vice President

It just may be tying into a couple of the specifics. We ended the quarter with a pipeline of $547 million, up from $492 million and more loan closings during the quarter than Q2. So we're heading in the right direction. It would get up in that high-single-digits. We've got to get the pipeline up from that $547 million 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, again, it depends on pay-offs. 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 million, $60 million and bump closings modestly on a monthly basis.

Matthew T. Clark -- Piper Sandler -- Analyst

Got it. Thank you.

Jeffrey J. Deuel -- Chief Executive Officer

Thanks, Matt.

Operator

Thank you, Mr. Clark. [Operator Instructions] There are no additional questions waiting in the queue. I would now like to pass the conference back to Jeff.

Jeffrey J. Deuel -- Chief Executive Officer

Well, Char, 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 good bye.

Operator

[Operator Closing Remarks]

Duration: 31 minutes

Call participants:

Jeffrey J. Deuel -- Chief Executive Officer

Donald J. Hinson -- Executive Vice President and Chief Financial Officer

Tony Chalfant -- Executive Vice President and Chief Credit Officer

Bryan D. McDonald -- Executive Vice President

Jeffrey A. Rulis -- D.A. Davidson & Co. -- Analyst

Matthew T. Clark -- Piper Sandler -- Analyst

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