Heritage Financial Corp

NASDAQ:HFWA

Earnings Call Analysis

Company's Positive Outlook Amid Rate Challenges

The company experienced an 11% increase in criticized loans, with a small rise in net charge-offs, ending the year in a solid net recovery position despite some deterioration compared to 2022. Fourth-quarter new loan commitments decreased to $187 million, forecasting a mid-single-digit growth rate in the upcoming quarters. Average interest rates for new loans have risen, attributable to higher index rates and widened spreads. The firm navigated the exit from the retail mortgage business and plans to supplement mortgage loan portfolio runoffs through wholesale channels. Executives expressed confidence in the company's risk management, capital position, and the ability to capitalize on market opportunities in 2024.

Steady Growth and Strong Positioning Amid Higher Rates and Market Challenges

The company witnessed a solid finish in the fourth quarter (Q4), marking an increase of $15 million or 11% from the end of the third quarter, despite some credit quality challenges with two significant commercial and industrial (C&I) relationships, demonstrating resilience in its commercial real estate portfolio. Importantly, the company is entering the new year in a position of strength, showcasing robust credit quality across its loan portfolio, which positions it well for the future.

Moderate Loan Demand and Pipeline Dynamics

New loan commitments closed at $187 million, a decline from the previous quarter but the company remains focused on growth, with a mid-single-digit growth rate anticipated over the next few quarters. The commercial loan pipeline shows promising signs, ending the fourth quarter at $329 million, up from the last quarter. This activity highlights the company's adaptability to the moderating loan demand driven largely by the impact of higher interest rates on customer behavior.

Rising Interest Rates and Strategic Exits

Increasing interest rates is a notable theme, as average rates for new commercial loans moved up to 6.93% in Q4. The rise in rates reflects a combination of higher index rates and widened spreads implemented throughout the year. In response to the challenging mortgage market, characterized by low origination volume, the company decided to exit the retail mortgage business and will look to balance portfolio runoff through periodic residential loan purchases.

Strategic Outlook: Long-Term Confidence and Expense Management

The company's leadership expressed confidence in their long-term prospects, buoyed by strong risk management, a solid capital position, and a relatively low loan-to-deposit ratio that provides a cushion to support current and new high-quality relationships. As part of its long-term strategy, the company will continue to hone in on expense management and improving efficiencies, ensuring it is well-positioned to navigate future market dislocations.

Net Interest Margin (NIM) Pressures and Interest Rate Cuts

Management anticipates some level of NIM compression, projecting numbers to possibly fall into the 330s for the quarter. The margin is affected by the cost of deposits, which, although increasing at a moderating pace, is expected to further compress the NIM due to rate cuts. While interest rate cuts may initially put pressure on margins, they are predicted to be beneficial in the long term, helping to correct the inverted yield curve situation. The bank has a blend of assets and liabilities that will reprice within the year, suggesting they will eventually reach an equilibrium in response to rate adjustments.

Financial Performance Indicators and Tax Rate

The fourth-quarter performance, excluding investment losses and the absence of gains on the sale of loans, is seen as a good indicator of a 'run rate' moving forward. Regarding fiscal matters, the anticipated tax rate for the upcoming year of 2024 is estimated to be between 16% to 16.5%, giving investors a sense of the potential tax obligation on future earnings.

Earnings Call Transcript 2023-Q4

[Operator]

Hello, everyone, and welcome to today's call. My name is Drew, and I'll be your conference operator today. At this time, I would like to welcome everyone to the Heritage Financial Q4 and Year-end Earnings Call. [Operator Instructions] I will now turn the call over to your host, Jeff Deuel, CEO. Please go ahead.

[Jeffrey J. Deuel, executive]

Thank you, Drew. Welcome to everybody who called in and those who may listen later. This is Jeff Deuel, CEO of Heritage Financial. Attending with me are Bryan McDonald, President and Chief Operating Officer; Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer.

Our fourth quarter earnings release went out this morning premarket, and hopefully, you have had the opportunity to review it prior to the call. We have also posted an updated fourth quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity and credit quality. We will reference the presentation during the call. Please refer to the forward-looking statements in the press release.

We are reporting a somewhat noisy quarter that ultimately sets us up well for 2024 and beyond. That so-called noise can be attributed to active balance sheet management and expense reduction measures. When we started to run the preliminary budget in 2024, noninterest expense was running around $171 million for the year. That, coupled with continued pressure on margins caused the management team to take a hard look at our org structure in Q4, and we were able to get that number down to a run rate more around $162 million.

In the end, expense reduction actions included contract rationalization, elimination of management layers, streamlining certain back-office operations and exiting our retail mortgage platform, all of which will be referenced in this presentation. We continue to see pressure on deposit pricing in Q4, and we expect to see this continue for the near term.

Deposit balances declined modestly in Q4, and the mix of deposits continues to partially shift to higher rate products. Loan growth was strong in Q4, running at a 7% annualized rate. Credit quality remains strong, resulting from our long-term practice of actively managing the loan portfolio. We have ample liquidity, a low loan-to-deposit ratio and a solid capital base. Going forward, we will keep a sharp eye on expenses while we focus on growing loans and deposits.

We'll now move on to Don Hinson, who will take a few minutes to cover our financial results.

[Donald Hinson, executive]

Thank you, Jeff. I will be reviewing some of the main drivers of our performance for Q4. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the third quarter of 2023. I want to start by covering some actions that significantly impacted earnings for Q4 and are expected to improve earnings in future periods.

First, we repositioned a portion of our investment portfolio, which resulted in a pretax loss of $10 million during the quarter. We sold $152 million of securities with a weighted average yield of 2.41% and purchased $141 million of securities yielding 6.08%. Including the yield and cash not yet reinvested at year-end, we are expecting an annualized interest income pickup of about $5 million from these transactions, resulting in an earn-back period of approximately 2 years.

Second, we incurred certain costs related to expense management measures in order to lower expenses in future periods. These included $1.5 million in contract negotiation fees, which will lower cost of the related contract over a 6-year period. $320,000 due to the write-off of a contract that we will not be replacing and $148,000 of severance payments to terminated employees.

As mentioned in the earnings release, these costs, in addition to approximately $1.2 million of severance payments expected to be incurred in Q1, will result in annualized cost savings of approximately $5.3 million. These and other expense management measures are being taken to improve our performance in 2024 and beyond. Please see Page 6 of the investor presentation for more information on these actions.

Moving on to the balance sheet. Loan growth was strong in Q4, increasing $69 million for the quarter. For the year, loan growth was $285 million or 7%. Yields in the loan portfolio were 5.35% for the quarter, which was 5 basis points higher than Q3. Bryan McDonald will have an update on loan production and yields in a few minutes.

Total deposits decreased $35 million during the quarter. The decrease was due to a decrease of almost $100 million in non-maturity deposits, partially offset by an increase of $64 million in CD balances. Customers continue to take advantage of the higher rate environment by lowering their excess balances in lower-paying non-maturity deposit accounts.

These factors contributed to an increase of 25 basis points in our cost of interest-bearing deposits to 1.48% for Q4. Due to the current market pressure related to deposit rates, we expect to continue to experience an increase in the cost of our core deposits. This is illustrated by the cost of interest-bearing deposits being 1.56% for the month of December with a spot rate of 1.59% as of December 31.

Investment balances decreased $21 million during Q4, partially due to the loss trade previously discussed. The security trades occurred from mid-November to mid-December. Therefore, the benefit of loss trade was not fully realized in Q4. Even without full realization of the loss trade benefit, the yield on the securities portfolio increased 16 basis points from the prior quarter to 3.15% for Q4.

Moving on to the income statement. Net interest income decreased $1.7 million from the prior quarter due to a decrease in the net interest margin and in average earning assets. The NIM decreased to 3.41% for Q4 from 3.47% in the prior quarter. The decrease in NIM was primarily due to the cost of interest-bearing deposits increasing more rapidly than yields on earning assets.

We expect NIM to decrease further in Q1 2024 since NIM for the month of December was 4 basis points lower than it was for the entire quarter, Q4.

The pace and duration of our decrease in margin will be highly dependent on continued increases in our cost of interest bearing deposits as well as maintaining deposit balances. Our cost of deposits as well as deposit balances as they level off, we expect to experience margin stabilization due to the repricing of adjustable rate loans in addition to higher origination rates on new loans.

In addition, current rates on brokered CDs are lower than those currently on our books, which will help mitigate other deposit cost pressures as these roll over.

We've recognized a provision for credit losses in the amount of $1.4 million during the quarter. The provision expense was due to a combination of loan growth and net charge-off of $618,000 recognized during the quarter.

Removing the impact of significant Q4 expense items previously mentioned, noninterest expense decreased from the prior quarter due partly to lower FTE levels. Average FTE for -- was 803 for Q4 compared to 821 for Q3. These levels will decrease further in Q1 and 2024 and are expected to decrease to less than 780 by Q2. All impacted employees have already been notified.

Due to the previously mentioned severance costs in Q1, Q1 noninterest expense levels are expected to be somewhat elevated from the go-forward run rate. Beginning in Q2, we expect the expense run rate to be between $40 million and $41 million.

All the regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio increased to 8.8% at year-end from 8.2% at the end of the prior quarter. This increase was due substantially to improvement in our AOCI as market rates improve the overall fair value of our securities portfolio.

I will now pass the call to Tony, who will have an update on our credit quality metrics.

[Tony Chalfant, executive]

Thank you, Don. Credit quality at year-end remained strong and was stable throughout the year. As of year-end, nonaccrual loans totaled just under $4.5 million, and we do not hold any OREO. This represents 0.10% of total loans and compares to 0.07% at the end of the third quarter.

Nonaccrual loans increased by $1.4 million during the quarter, however, were down by 24% over the last 12 months. Increases of just over $2.1 million in the quarter came from moving 1 C&I loan to nonaccrual status. A portion of this loan was charged off during the quarter and the remaining balance is fully guaranteed by the SBA. We expect to be fully repaid from the guarantee during 2024. Partially offsetting this increase was $746,000 in loans that were either upgraded to accruing status or were paid off during the quarter.

Page 26 of the investor presentation reflects the significant improvement we have experienced in our nonaccrual loan levels since the end of 2020.

Loans that are delinquent more than 30 days and still accruing stood at 0.11% of total loans at year-end. This is unchanged from the third quarter and is down from 0.17% of total loans at year-end 2022. Criticized loans, those risk-rated special mention or worse totaled just under $150 million at the end of the quarter. This is an increase of $15 million or 11% from the end of the third quarter. The largest driver of this increase was the downgrade of 2 significant C&I relationships.

During the quarter, a $7.1 million relationship was moved to special mention and a $6 million relationship was moved to substandard. Overall, criticized loans have trended modestly higher since the end of 2022, rising by 11% over this 12-month period.

Our commercial real estate portfolio continues to perform well and has shown some improvement over the last 12 months. Total criticized CRE loans represent 3.4% of our total CRE portfolio and 2.3% of our entire loan portfolio. As of year-end 2022, the percentages were 4.8% and 3.2%, respectively.

The credit quality of our office loan portfolio has remained stable over the last quarter and throughout 2023. This loan segment currently represents $556 million or 12.8% of total loans and is split evenly between investor CRE and owner occupied. The loans continue to be granular in size and diversified by geographic location with little exposure in the core downtown markets. Criticized office loans are limited to just over $19 million, which is down modestly from the $21.5 million reported at the end of the third quarter.

Page 25 of the investor presentation provides more detailed information about our office loan portfolio. During the fourth quarter, we experienced total charge-offs of $709,000 with the majority attributed to 2 C&I borrowing relationships. The losses were offset by $91,000 in recoveries, leading to a net charge-off of $618,000 for the quarter, which was referenced by Don earlier. We ended 2023 in a net recovery position of $277,000. While the recovery position was lower than 2022, loan losses remained very low when compared to historical norms.

Page 28 of our investor presentation shows that we continue to outperform the average of our peer group in this important credit metric. While there was some modest deterioration over the last 12 months, the credit quality of our loan portfolio remains strong, and we are well positioned heading into the new year. The slight uptick in criticized loans during the quarter suggests a move towards a more normalized credit environment following a period of exceptionally high credit quality. We remain confident that our consistent and disciplined approach to credit underwriting is designed to generate solid credit performance in a wide range of business cycles.

I'll now turn the call over to Bryan for an update on loan production.

[Bryan McDonald, executive]

Thanks, Tony. I'm going to provide detail on our fourth quarter loan production results, starting with our commercial lending group.

For the quarter, our commercial teams closed $187 million in new loan commitments, down from $217 million last quarter and down from $329 million closed in the fourth quarter of 2022.

Please refer to Page 20 in the fourth quarter investor presentation for additional detail on new originated loans over the past 5 quarters. The commercial loan pipeline ended the fourth quarter at $329 million, up from $291 million last quarter and down from $536 million at the end of the fourth quarter of 2022. Loan demand continues to be moderate due primarily to the effects of higher interest rates.

Loan growth for the fourth quarter was $69 million, up from $15 million last quarter due to more significant advances on construction commitments and higher balances on loans closed during the quarter. Please see Slides 21 and 23 of the investor presentation for further detail on the change in loans during the quarter.

Based on our current pipeline, we anticipate our growth rate will be mid-single digits over the next couple of quarters. The deposit pipeline ended the quarter at $207 million compared to $171 million last quarter, and estimated average balances on new deposit accounts opened during the quarter totaled $55 million. This compares to $39 million in actual new balances on accounts added in the third quarter.

Moving to interest rates. Our average fourth quarter interest rate for new commercial loans was 6.93%, which is 48 basis points higher than the 6.45% average for last quarter. In addition, the average fourth quarter rate for all new loans was 7.04%, up 50 basis points from 6.54% last quarter. The increase is due to a combination of higher underlying index rates and widened spreads implemented in 2023. The market continues to be competitive, particularly for C&I relationships.

The mortgage department origination volume and pipeline continue to be low in the fourth quarter. Ongoing low loan volume, combined with uncertainty around when we could expect to see our mortgage business improve led to our decision to exit the retail component of this business line. The staff associated with the retail mortgage business are included in the non-interest expense numbers Don shared a few minutes ago. We expect to replace portfolio balance runoff with periodic residential loan purchases, including through an existing wholesale production channel.

I'll now turn the call back to Jeff.

[Jeffrey J. Deuel, executive]

Thank you, Bryan. As we mentioned earlier, we're pleased with our performance in the fourth quarter, which sets us up for 2024. While we continue to experience the challenges of the rate -- this current rate environment, we're confident that the strength of our franchise will continue to benefit us over the long term. Our relatively low loan-to-deposit ratio positions us well to continue to support our existing customers as well as pursuing new high-quality relationships.

We will continue to benefit from our solid risk management practices and our strong capital position. We will continue to focus on expense management and improving efficiencies within the organization. Overall, we believe we are well positioned to navigate the challenges ahead and take advantage of any potential dislocation in our markets that may occur.

That is the conclusion of our prepared comments. So Drew, we're ready to open up the call to any questions callers may have for us.

[Operator]

[Operator Instructions] Our first question today comes from Jeff Rulis from D.A. Davidson.

[Jeff Rulis, analyst]

Just maybe a question for Don. On the margin side, I heard your comments about expecting further compression. I wanted to kind of get the sense for -- with the security sale, that's inclusive of that and kind of relative compression is that magnitude moderating 3Q, 4Q to 1Q?

[Donald Hinson, executive]

Jeff, I'll be happy to answer that for you. The -- as I mentioned, the December NIM dropped, but like I said, it didn't have include all of the loss trade, but we're still with the cost of deposits increasing, although moderating, I do expect that we see NIM compression down again, maybe a little less so than we saw from Q3 to Q4 but still probably into the 330s for the quarter.

[Jeff Rulis, analyst]

Okay. And if you could just remind us on kind of if and when we get some rate cuts, I don't know about the sensitivity of each 25 basis point cut, what that initially does and maybe a little further out, the impact to the margin?

[Donald Hinson, executive]

I think if I'm going to start with long term, I think long term, more rate cuts will be beneficial because any time we can get away from an inverted yield curve, that's going to help us out. But in the short run, with rate cuts, we're going to -- there's always a lag period on cutting deposit rates and having those reprice whereas the -- we have about $1.2 billion in floating rate assets.

I will say, though, we -- when you add up our brokered CDs, other CDs, we have some floating rate public deposits and some -- and our exception price core deposits, that adds up to about $1.4 billion in and of itself that will reprice over a year also. So I think over a year, they'll kind of, I guess, reach equilibrium over rate cuts. But in the short run, I think it's going to hurt margin more. And I don't have necessarily a specific number for you, but you can see the amount of floating rate that we have in each category.

[Jeff Rulis, analyst]

Sure. And then just a couple of housekeeping. Just on the fee income side, resumption of a normalized kind of $7 million to $7.5 million clip. Is that a quarterly a fair run rate?

[Donald Hinson, executive]

I think what we did in Q4, obviously, ex the losses on the investments. And of course, we wouldn't have any gains on sale of loans, other than those, I think that's a pretty good run rate.

[Jeff Rulis, analyst]

Okay. And then the tax rate for '24, should we think about 16% or 17%?

[Donald Hinson, executive]

Yes. I think somewhere between 16%, 16.5% is probably kind of where we're going to end out.

[Operator]

[Operator Instructions] Our next question comes from Matt Fedorjaka from KBW.

[Matthew Fedorjaka, analyst]

Wanted to see what you're seeing kind of what deposit balances maybe with NIVs early into the year here, if you have any insight to where you think they might may bottom at? And what the deposit flows are kind of looking like early into this year?

[Jeffrey J. Deuel, executive]

Don, do you want to take that?

[Donald Hinson, executive]

Sure. We have seen continued decrease of our percentage of noninterest-bearing. We're down to a little over 30%, I think 3.7% as of the end of the year. Pre-pandemic, we were 31.6%, I think it was. But obviously, we're in a different rate environment. So at this point, I kind of based off the trends, I kind of would expect that overall percentage to drop into the high 20s at this point. I don't necessarily see it going below that, but the trends continue as far as over the last few quarters. So I don't see at this point where it's going to slow down until we see maybe some changes in the rate environment.

[Matthew Fedorjaka, analyst]

All right. Great. And then maybe on the other side of -- with loans, I appreciate the guidance of mid-single digits. Maybe you guys could talk about where you're seeing some good opportunities this year and where you think you might see like the most growth in 2024?

[Jeffrey J. Deuel, executive]

Bryan, do you want to take that?

[Bryan McDonald, executive]

Sure. It's -- Matt, this is Bryan McDonald. Really, it's broad-based. Our bankers have been calling with an added emphasis on C&I since last spring, we've always been a C&I banker, but as the market conditions changed, more of a heavy emphasis on full relationship. But it's really up and down the footprint. Of course, our new teams have more bankers with lower portfolio sizes, and so they're able to get out and call more than our bankers with large portfolios, but it's all across the network.

[Matthew Fedorjaka, analyst]

Great. And then one more here. Are you guys -- any appetite or expecting any more restructuring this year at this time? Or do you think that will be it?

[Jeffrey J. Deuel, executive]

Restructuring, you mean of the balance sheet?

[Matthew Fedorjaka, analyst]

Yes, yes.

[Jeffrey J. Deuel, executive]

Okay. Go ahead, Don.

[Donald Hinson, executive]

Okay. We're considering it. We haven't made any final decisions on that. I would say it's a less attractive trade than it was last quarter or maybe in the quarter before that. So with potential longer earn-back periods and less pickup -- income pickup. I will say that we -- if we did another one, we'd probably try to keep it within 3 years. As a reminder, the last one was 2 years the earn back. But we haven't made any final decisions.

[Operator]

[Operator Instructions] We have no further questions in the queue, so I'll go back over to Jeff for any using remarks.

[Jeffrey J. Deuel, executive]

Well, thank you, Drew. Since there's no more questions, I guess, we wrap up the quarterly call. Well thank you all for your time and your support and your interest in our ongoing performance, and we'll hopefully see some of you soon.

[Operator]

That brings us to the end of today's call. There will be a replay available for the call. Please dial [phone]. Please use the access code of 301843. That concludes today's Heritage Financial Q4 and year-end earnings call. You may now disconnect your lines.