Heritage Financial Corporation (NASDAQ:HFWA) Q2 2023 Earnings Call Transcript
Heritage Financial Corporation (NASDAQ:HFWA) Q2 2023 Earnings Call Transcript July 20, 2023
Heritage Financial Corporation reports earnings inline with expectations. Reported EPS is $0.48 EPS, expectations were $0.48.
Operator: Hello, and welcome to the Heritage Financial Corporation Q2 2023 Earnings Conference Call. My name is Elliot, and I'll be coordinating your call today. [Operator Instructions] I'd now like to hand over to Jeff Deuel, CEO. The floor is yours. Please go ahead.
Jeffrey Deuel: Thank you, Elliot. Welcome, and good morning to everyone who called in and those who may listen later. This is Jeff Deuel, CEO of Heritage Financial. Attending with me are Don Hinson, Chief Financial Officer; Bryan McDonald, President and Chief Operating Officer; and Tony Chalfant, Chief Credit Officer. Our second 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 second 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 this presentation during the call.
Please refer to the forward-looking statements in the press release. We're very pleased to report another solid quarter with EPS in line with consensus. We continue to see pressure on deposit pricing in Q2, and we expect that to continue for the balance of the year. Deposit movement in Q2 was primarily tied to normal flows, including capital purchases with a lesser portion tied to alternative investments. FDIC insurance-related concerns have substantially subsided. We reported solid organic loan growth of 3% for the quarter as we focus on supporting our existing customers and pursuing new relationships with a primary focus on C&I. We are pleased with the positive trend of new commitments and new loan closings from our existing production teams and the newer teams added over the past year.
We continue to manage expenses carefully, although we also continue to experience the impacts of inflation, mostly on compensation costs. Notably, our long-standing focus on credit quality and actively managing our loan portfolio continues to play out well for us. Staying focused on our conservative risk profile has enabled us to continue to report strong credit metrics and provides a good foundation as credit quality returns to more historical levels. We'll now move on to Don who will take a few minutes to cover our financial results.
Donald Hinson: Thank you, Jeff. I will be reviewing some of the main drivers of our performance for Q2 as I walk through our financial results. Unless otherwise noted, all of the prior period comparisons will be with the first quarter of 2023. Starting with net interest income, we experienced a decrease of $4 million or 6.7% in Q2 due mostly to an increase of $7.4 million in interest expense. This increase in interest expense resulted from a combination of an increase in our cost of interest-bearing deposits and an increased use of borrowings during the quarter. This was the main driver for the 35 basis point decrease in our net interest margin in Q2. As mentioned earlier, we had a solid loan growth of $124 million or 3% in Q2.
In addition, yields on the loan portfolio were 5.19% for the quarter, which was 12 basis points higher than Q1 and contributed to an 11 basis point increase in yield on earning assets. Bryan McDonald will have an update on loan production and yields in a few minutes. Our cost of interest-bearing deposits increased 43 basis points to 0.92% for Q2. We continue to experience market pressure related to deposit rates. We are strategically increasing our deposit rates by product and working individually with our customers to maintain relationships. As a result of the current rate environment, we expect to continue to experience an increase in the cost of our core deposits, although at a slower pace than in Q2. The continued but slowing increase in this cost is illustrated by the cost of interest-bearing deposits being 1% for the month of June with a spot rate of 1.04% as of June 30.
Overall, we experienced a decline in deposit balances of 3.3% for the quarter. The decline occurred primarily in April, which is a month that typically experiences decreases in deposit balances due to tax payments Deposit balances were relatively flat during the last two months of the quarter. Bryan will discuss our deposit pipeline later in the presentation. Our insured deposits were at 67% of total deposits at June 30 compared to 65% at March 31. Also for customers seeking additional FDIC insurance, we offer deposit products, which have full FDIC insurance. On balance sheet, deposit totals for these accounts were $219 million at the end of Q2. In order to supplement our funding, we borrowed $450 million from the Federal Reserve's Bank Term Funding Program or BTFP, and paid off existing FHLB advances.
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We utilized the BTFP due to the lower cost and fixed rate nature of the notes as well as the option to prepay borrowings at any time. The blended rate on the BTFP advances was 4.72% in Q2 compared to an average cost of 5.15% for the FHLB advances for the quarter. You can refer to Pages 38 and 39 of the investor presentation for more specifics on our borrowings and liquidity position. As I previously mentioned, we experienced a sizable decrease in NIM to 3.56% for Q2 from 3.91% in the prior quarter. We expect NIM to decrease further in Q3, although not as significantly. This can be illustrated by a NIM of 3.54% for the month of June, which is only 2 basis points lower than for the entire second quarter. 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.
As our cost of deposits as well as deposit balances 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. Moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds and our TCE ratio was at 8.3%, unchanged from the prior quarter. In addition, with a loan deposit ratio of 76%, we have plenty of liquidity to continue to grow our loan portfolio. Noninterest income decreased from the prior quarter, primarily due to a $1.6 million onetime gain on the sale of Class B Visa stock, which occurred in Q1. Noninterest expense decreased $280,000 to $41.3 million in Q2. This was due mostly to a decrease in the accrual for incentive-based compensation resulting from lower expected earnings this year.
Looking ahead, we expect noninterest expense to be in the low $42 million range for Q3. The effective tax rate decreased to 15.2% in Q2 from 17.1% in Q1 in order to adjust the year-to-date effective tax rate to the current estimated rate for 2023, which is now at 16.3%. And finally, moving on to the allowance, even though we continue to show strong credit quality metrics, we recognized a provision for credit losses of $1.9 million during the quarter due mostly to increases in loan balances. I will now pass the call to Tony, who will have an update on these credit quality metrics.
Anthony Chalfant: Thank you, Don. I'm pleased to report that credit quality remained strong and stable through the first six months of the year. As of June 30, nonaccrual loans totaled $4.6 million, and we do not hold any OREO. This represents 0.11% of total loans and 0.07% of total assets. Nonaccrual loans declined modestly during the quarter and are now down by $5.8 million or 56% over the last 12 months. We did not move any loans to nonaccrual status during the quarter. The reduction came from payments on loans that were applied to principal. Page 25 of the investor presentation highlights the positive trends in our level of nonperforming assets. Delinquent loans, which we define as those over 30 days past due and still accruing represented 0.09% of total loans or $3.9 million at quarter-end.
This compares favorably to $8.4 million or 0.20% of total loans at the end of the first quarter. Criticized loans, those risk-rated special mention and substandard, totaled just over $143 million at the end of the quarter. This is a modest decrease of $2.4 million from the end of the first quarter. Criticized loans have increased by $8 million since year-end 2022. However, over the past 12 months, they've declined by $23.2 million or 14%. Notably, over the same 12-month period, loans risk-rated substandard have declined by $35.8 million or nearly 38%. Overall, our entire CRE portfolio continues to perform well and has been stable through the first six months of 2023. Total criticized CRE loans represent just 2% of our entire loan portfolio.
While we continue to closely watch our portfolio of office loans, we have yet to see any material deterioration in credit quality. At quarter-end, criticized office loans totaled approximately $25 million. This represents just over 4% of our total portfolio of owner and non-owner occupied office loans. This is very consistent with what we reported at the end of the first quarter. In the second quarter, we did a detailed review of our non-owner occupied office loans that were $1.5 million or larger. This review included 52 loans that represent 65% of the outstanding balance of this portfolio. The focus was on net operating income, current occupancy levels, potential tenant rollover risk and evaluating risks around any renewal or repricing event occurring over the next 12 months.
I'm pleased to report that no loans were downgraded to special mention or worse as a result of this review. While we expect to see some future deterioration of credit quality in this portfolio, the performance to date remains stable. Page 24 of the investor presentation is new this quarter and provide a more detailed information about our office loan portfolio. During the second quarter, we experienced total charge-offs of $144,000. They were partially offset by recoveries of $95,000 leading to net charge-offs of just $49,000 for the quarter. Through the first six months of the year, total net charge-offs were $279,000. While trending higher than what we experienced in 2022, loan losses remained very low when compared to historical norms. As I've stated in previous earnings calls, our average annual net charge-offs for the three-year period 2018 through 2020 was approximately $2.9 million or about $700,000 a quarter.
We remain disciplined in our underwriting through all business cycles and maintain a detailed approach to concentration management. This has led to a loan portfolio that is both granular and well diversified by loan type and geography. In these turbulent times, we're pleased that our credit metrics remain strong and stable. The bank remains well positioned for any potential downturn in economic conditions over the coming quarters. I'll now turn the call over to Bryan for an update on loan production.
Bryan McDonald: Thanks, Tony. I'm going to provide detail on our second quarter loan production results, starting with our commercial lending group. For the quarter, our commercial teams closed $212 million in new loan commitments, down from $228 million last quarter and down from $283 million closed in the second quarter of 2022. Please refer to Page 19 in the second quarter investor presentation for additional detail on new originated loans over the past five quarters. The commercial loan pipeline ended the second quarter at $473 million, down from $587 million last quarter and down from $537 million at the end of the second quarter of 2022. Loan growth was $124 million for the quarter, which is above historical levels due to lower prepay volumes and increased balances on construction loans closed last year.
Please see Slides 20 and 21 in the investor deck for further detail on the change in loans during the quarter. Considering current market conditions, trends in our portfolio and customer base, our quarter end loan pipeline and the fact our new Boise team is just ramping up production. We anticipate a strong but moderately lower level of loan growth for the next couple of quarters. The deposit pipeline ended the quarter at $118 million and balances associated with new deposit customer accounts opened during the quarter totaled $46 million. Moving to interest rates. Our average second quarter interest rate for new commercial loans was 6.16%, which is 19 basis points higher than the 5.97% average for last quarter. In addition, the average second quarter rate for all new loans was 6.27%, up 26 basis points from 6.01% last quarter.
The increase is due to a higher percentage of loans being closed under widened spreads implemented in 2023 versus working through the pipeline coming into the year that include pricing committed at lower levels. The market continues to be competitive, particularly for C&I relationships. The mortgage department closed $25 million of new loans in the second quarter of 2023 compared to $17 million closed in the first quarter of 2023 and $40 million in the second quarter of 2022. The mortgage loan pipeline ended the quarter at $13 million versus $25 million last quarter and $20 million at the end of the second quarter of 2022. With mortgage rates remaining at higher levels, we anticipate volumes will continue at the relatively low levels we have seen year-to-date.
I'll now turn the call back to Jeff.
Jeffrey Deuel: Thank you, Bryan. As I mentioned earlier, we're pleased with our performance in the second quarter. We're confident our well-established granular deposit franchise will continue to be an area of strength for us, and we have ample liquidity sources. 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 historically conservative approach to credit in our strong capital position, and we operate in a footprint that is economically vibrant. We will continue to focus on expense management and improving efficiencies within the organization. Overall, we believe we are positioned to navigate the challenges ahead to take advantage of any potential dislocation in our markets that may occur. That is the conclusion of our prepared comments. So Elliot, we are ready to open up the call to any questions callers may have for us.
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