Heritage Financial Corporation (NASDAQ:HFWA) Q2 2022 Earnings Conference Call July 21, 2022 2:00 PM ET
Company Participants
Jeff Deuel – Chief Executive Officer
Donald Hinson – Executive Vice President and Chief Financial Officer
Tony Chalfant – Executive Vice President and Chief Credit Officer
Bryan McDonald – President and Chief Operating Officer
Conference Call Participants
Adam Butler – Piper Sandler & Co.
Kelly Motta – Keefe, Bruyette & Woods, Inc.
Operator
Good afternoon. Thank you for attending today’s Heritage Financial Corporation Q2 2022 Earnings Call. My name is Bethany, and I will be your moderator for today’s call. All lines will be muted during the presentation portion of the call with an opportunity for questions and answers at the end. [Operator Instructions]
I would now like to pass the conference over to our host, Jeff Deuel, CEO of Heritage Financial Corporation. Please go ahead.
Jeff Deuel
Thank you, Bethany. Welcome, and good morning to everyone who called in and to 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 earnings release went out this morning pre-market and hopefully you had an 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 website, which can be found at heritagebanknw.com. We will reference the presentation during the call. Please refer to the forward-looking statements in the press release.
We are happy to report another solid quarter in Q2. Organic loan growth was 5.6% annualized and was aided by lower payoffs, higher line utilization, and a pool of purchased residential mortgage loans. Annualized loan growth ex-PPP was 11.2% for the quarter. We are pleased with the positive trend we see in the number of new commitments and new loan closings. Our production teams are performing quite well in the current market.
We also continue to focus on deposit growth and although we saw some deposit runoff this past quarter, deposit balances began to pick up again after quarter end. Our pipeline of loans and deposits are strong and we expected to continue to grow through the year. We are pleased to report that during the second quarter, we expanded our existing presence in the Portland-Vancouver MSA and gained entry to the Eugene, Oregon market through the hiring of four new commercial banking teams. We believe these new teams will begin to contribute to our new loan and deposit growth in Q3.
NIM is improving with the deployment of cash in the loans, higher rates on deposits of the Fed and increases to the investment portfolio. Don and his team have done a nice job carefully managing our balance sheet over the past couple of years and we are pleased with the results.
We maintained our focus on carefully managing expenses with good success as evidenced in the overhead ratio of 1.94%. However, we do expect that ratio to shift up a bit over the next couple of quarters with the addition of the new teams. Notably, our longstanding focus on credit quality and actively managing our loan portfolio continues to play out well for us. Staying focused on our moderate risk profile has enabled us to continue to report improving credit trends and provide a good foundation as we face a potential recession. We also continue to benefit from the recapture of the reserve build from 2020. ACL is now settling in at 1.03% ex-PPP compared to the pre-pandemic ACL of 1.01%.
We will now move to Don who will take a few minutes to cover our financial results.
Donald Hinson
Thank you, Jeff. As Jeff mentioned, overall financial performance was very positive in Q2 and I’ll be reviewing some of the main drivers of our performance. As I walk through our financial results, unless otherwise noted, all the prior period comparisons will be with the first quarter of 2022.
Starting with net interest income, there was an increase of $3.1 million due mostly to improved deals on earning assets and the leveraging of cash into investments and loans partially offset by a decrease in income from PPP loans. PPP loans decreased $54 million to a balance of $11 million at quarter-end and their impact on net interest income decreased by $1.3 million from the prior quarter. The impact from PPP loans would be much less significant for the remainder of the year.
Excluding the decline in PPP balances, loans increased to $106 million during the quarter, which is up from the increase of $86 million in Q1. In addition, investments increased $341 million due to increased levels of purchasing in Q2 in order to take advantage of improved market rates. As a result of the increases in loans and investments, as well as a decrease of $161 million in total deposits, our interest earning deposits held at other banks decreased $588 million during the quarter.
However, interest earning deposits is still at a very healthy $900 million at the end of Q2, which provides opportunities for further growth into higher yielding loans and investments. Due mostly to the leveraging of our cash and higher yields on interest earning assets, our net interest margin increased 20 basis points from the prior quarter.
As expected Q1 appears to be the floor for our net interest margin in this rate cycle and we expect to continue to benefit from the current rate environment and expected additional rate hikes. Growth in loan yields was muted in Q2 by the runoff of PPP loans and a 10 basis point decrease in the impact of interest recoveries on non-accrual loans compared to the prior quarter.
As I previously mentioned, we experienced a decline in deposit balances during the quarter. This is not surprising given the overall decline in deposits that banks experienced in Q2, cost of total deposits were 9 basis points for the quarter, the same level as the previous three quarters as shown on Page 26 of the Investor Presentation. We do expect to begin to see incremental increases in the cost deposits over the coming quarters.
All of our regulatory capital ratios remain strongly above well capitalized thresholds and we continue to have a very strong liquidity position. Our TCE ratio is at 7.9% unchanged in the prior quarter. This was due to strong earnings and a decrease in total assets offsetting the impact of investment fair value marks on the AOCI portion of equity. Due to the impact of market rates on equity, which is both unrealized and somewhat volatile, we have begun to report the TCE ratio and tangible book value per share, both with and without the impact of AOCI.
As of the end of Q2, AOCI had an 80 basis point impact on the TCE ratio and $1.76 impact on the tangible book value per share. You can refer to Page 31 under the investor presentation for more specifics on capital and liquidity. Non-interest income decreased $1.5 million from the prior quarter due primarily to a $1 million decrease in BOLI income from the Q1 recognition of a death benefit.
We have continued to see improvement in our overhead ratio. Our overhead ratio decreased to 1.94% compared to 1.95% in the prior quarter. However, due to a combination of the hiring of production teams, continued technology investments and inflationary pressures on our internal pay scales, we do expect to see our expenses increased over the next few quarters.
As has occurred over the past several quarters, our earnings for Q2 were positively impacted by a reversal of provision for credit losses in the amount of $1.2 million. The reversal was mostly due to a $1.7 million reduction in required allowance for individually evaluated non-accrual loans. In addition, we also lowered the allowance on unfunded commitments by 555,000 due mostly to a higher utilization rates. Without these two items, we would not have had a reversal provision in Q2.
I will now pass the call to Tony, who will have an update on our credit quality metrics.
Tony Chalfant
Thank you, Don. We saw continued improvement in our credit quality in the second quarter, and I’m pleased to report that the overall quality of our loan portfolio remains strong through the first half of the year. As of June 30, non-accrual loans, totaled $10.5 million. This represents 0.27% of total loans and 0.14% of total assets.
During the second quarter, non-accrual loans declined by $6.1 million or 37%. We have reduced non-accrual loans by $13.3 million or 56% from year-end 2021 and are now down 82% from December 31, 2020, which was the high point in this credit cycle. The significant improvement during the second quarter was primarily due to our ability to return two loans to non-accrual status.
These two borrowers had been significantly impacted by COVID and both have improved their financial performance to a point where an upgrade was warranted. As has been the case over the last several quarters, we did not have any new significant additions to our non-accrual loan totals. During the quarter, we had just one borrowing relationship moved to non-accrual status with an outstanding balance of 720,000.
Our delinquent loans, which we define as those over 30 days past due and still accruing remains at a very low 0.11% of total loans. Page 23 of the investor presentation highlights our success in reducing non-performing assets. Criticized loans those risk rated special mention and substandard declined by approximately 5% or $8 million in the second quarter and are now down 9% from year-end 2021. As of June 30, criticized loans totaled $166 million or 4.3% of total loans.
At year-end 2020, criticized loans were $291 million and our current level represents a 43% decrease from that high point. Our hotel portfolio continues to represent a higher than normal percentage of our criticized loans. This category of loans at $57.5 million represents approximately 35% of criticized loans. We continue to see improving trends in this portfolio and saw a reduction of $6 million during the quarter in loans that were either paid in full or were upgraded to past status.
With the rebound, we continue to see in the travel industry, we expect to upgrade more of these hotel loans over the second half of the year. As it stands currently, even with the continued impact from this portfolio, we are just $24 million higher than where our criticized loans stood at year-end 2019. We consider this to be a normalized level before the effects of the pandemic began to impact the loan portfolio. For more detail on these COVID impacted industries that we continue to closely monitor, please refer to Page 22 in the investor presentation.
During the second quarter, we experienced charge-offs of $249,000 split fairly evenly between commercial and consumer loans. This was offset by recoveries of 261,000, leading to a net recovery of $12,000 for the quarter. Year-to-date, we are on a net recovery position of $506,000. Loan losses remain at historically low levels. Total net charge-offs for the last four quarters combined were $352,000.
As a comparison, average annual net charge-offs for the three-year period 2018 through 2020 were approximately $2.9 million. While we are very pleased with the credit quality across our portfolio, we are beginning to see more impact on our borrowers from economic headwinds, such as labor shortages, supply chain issues and generally higher operating costs.
As we move through the second half of 2022 and into 2023, we are expecting to see some modest deterioration in credit quality. Given that we are currently in such a strong position, we are not overly concerned as this may just be a move back to a more normalized credit cycle.
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 $284 million in new loan commitments up from $224 million last quarter, and up from $152 million closed in the second quarter of 2021. Please refer to Page 18 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 $537 million up from $527 million last quarter and up from $492 million at the end of the second quarter of 2021. We saw a pullback in new loan discussions in the middle of the quarter, including a few construction projects being put on hold. This changed as we got later in June in the current level of loan demand is similar to what we were seeing earlier in the year.
Organic loan growth during the quarter was augmented with the purchase of a residential mortgage pool and negatively impacted by the runoff of both the SBA PPP balances and the indirect loan portfolio, a business line we discontinued in 2020. Excluding the impact of SBA PPP, indirect loan balance declines and the residential mortgage pool purchase provides a good measurement of our core organic loan growth rate. Using this measurement, loans increased $93 million during the quarter or a 10.18% annualized rate. Similar to the first quarter, we benefited from higher utilization rates and lower prepayment and payoffs as compared to 2021. All of which is detailed on slides 19 and 20 of the investor deck.
Consumer loan production, the majority of which are home equity lines of credit was $43 million during the quarter, which is up from $22 million last quarter and up from $23 million in the second quarter of 2021.
Moving to interest rates. Our average second quarter interest rate for new commercial loans was 4.11%, which is 57 basis points higher than 3.54% average for last quarter. In addition, the average second quarter rate for all new loans was 4.05% up 66 basis points from 3.39% last quarter.
Although the marketplace continues to be very competitive, we are seeing a portion of the recent rate increase translate into higher quoted interest rates on new loans. The mortgage department closed $40 million of new loans in the second quarter of 2022 compared to $37 million closed in the first quarter of 2022 and $49 million in the second quarter of 2021. The mortgage pipeline ended the quarter at $20 million versus $27 million in Q1 and $41 million in the second quarter of 2021.
Refinances made up 42% of the pipeline at quarter-end. With interest rates rising we anticipate refinance volumes will continue to decrease and the overall mortgage volume will trend down in 2022.
I’ll now turn the call back to Jeff.
Jeff Deuel
Thank you, Bryan. As we mentioned earlier, we are pleased with our performance in the second quarter, we are seeing solid organic production across the bank with deals coming from existing customers and new high-quality prospects. We are targeting Q3 loan growth in the low-to-mid double-digit range, which is consistent with Q2 loan volume ex-PPP. We will continue to focus on expense control in 2022, although as mentioned, we are experiencing general compensation pressures like everyone else.
We have also continued to focus on our technology strategy, which is designed to support more efficient operations, a more consistent customer experience and positions us well to pivot as bank technology continues to evolve, and we continue to grow. As a reminder on Page 7 of the investor deck, we have included a graphic overview of our technology strategy. We are also prepared to pursue acquisitions in our three-state region when we see the right opportunities for us. In the meantime, we will continue to focus on organic opportunities throughout the footprint.
As Don mentioned earlier, our capital levels and our robust liquidity provides us with a strong foundation to address challenges and take advantage of opportunities. That’s the conclusion of our prepared comments.
So Bethany, we’ll be happy to open up the call and take questions that people may have.
Question-and-Answer Session
Operator
[Operator Instructions] First question comes from the line of Jeff Rulis with D.A. Davidson. Please go ahead.
Unidentified Analyst
Thank you. Good morning.
Jeff Deuel
Good morning.
Unidentified Analyst
This is actually [indiscernible] on for Jeff Rulis. Just a question on loan growth. Will there be a revision to loan growth given the strength of this quarter’s core loan growth?
Jeff Deuel
Well, I think whatever revision there would be, we just mentioned earlier that we expect third quarter loan growth to be in the low-to-mid double-digit range, which we think is consistent with what we saw in Q2 ex-PPP. I know saying ex-PPP for much longer is not going to make much sense, but that’s how we are kind of tracking our core loan growth. Hopefully that answers your question.
Unidentified Analyst
Absolutely. Thank you. Another question on the new loan officers that were hired. Did you guys have any production from them this quarter? Or is production anticipated for the rest of the year?
Jeff Deuel
We had I think one deal closed in Q2, so not a lot of activity yet, but the pipeline is developing and we really didn’t expect to really see much from these teams until the third quarter.
Unidentified Analyst
Thank you. That’s helpful. And then last question for me, just appetite on buybacks going forward?
Jeff Deuel
Well, that’s a question for Don, so I’ll pass him the mic.
Donald Hinson
Yes. Our stamp on that hasn’t changed much over the last quarter, TCE ratio still at 7.9. So we’re going to continue to probably just buyback enough to keep the share count the same as far as when I’m talking about stock awards that are besting. So other than that, we’re probably not going to be very involved in buybacks this coming quarter.
Unidentified Analyst
Got it. Thank you.
Jeff Deuel
Thank you, Andrew.
Operator
Thank you. Our next question comes from the line of Adam Butler with Piper Sandler. Please go ahead.
Adam Butler
Thank you. This is Adam calling in for Matthew Clark, and thanks for taking the questions. With regard to your expectations for low double-digit loan growth in Q3, do you expect that growth to come from any specific segments or for it to be more broad based?
Jeff Deuel
Thanks for the question, Adam. I have every reason to believe it will be more broad based than anything else, but Bryan, you may have some thoughts on that that you might add.
Bryan McDonald
Yes, I agree. Adam, I think if you look at the detail in the release, C&I was up $47 million. We’ve continued to see utilization move up. We’re hoping that continues. Consumer was down a little bit, down about $4 million, but some of our – that was indirect consumer runoff of about $14 million during the quarter. So seeing some growth in that home equity balance and we would expect that to continue as well. So I think if you look at changes for the quarter, I think it’s going to be pretty representative of what we’re going to see going forward.
On residential mortgage, of course, we’ve done the pool purchases, but we’ve also seen a disproportionate percentage of the new loan originations going into portfolio business, last year, all of 2021 about 46% of the volume went into secondary market and this year it’s down to around 16%. So most of what we’re doing on the origination side is also going into the portfolio. So I think if you use Q – change from Q1 to Q2, good representation of what you’ll see in the rest of the year.
Adam Butler
Okay. Thank you. That’s very helpful. And then switching over to your credit expectations, are there any – you mentioned that you might see some deterioration moving forward. Are there any specific areas that you’re focusing on or just expect to see deterioration in general? Thanks.
Tony Chalfant
Yes. This is Tony. I’ll go ahead and take that. I think it’ll be – probably if I was going to say where we could see some deterioration, probably be more with C&I at this point. An example I’ve used in other meetings is, like a restaurant for example, might be back to pre-pandemic levels from a revenue standpoint, but they’re seeing just elevated costs both from a cost of goods sold and also from their labor pool. So those are the kind of things we’re seeing, impact as we go forward. The commercial real estate market generally the areas we are focused in has been strong and we think that’ll continue to be pretty strong at least for the near-term.
Adam Butler
Okay. Great. I think that’s all and congrats on the quarter.
Jeff Deuel
Thanks, Adam.
Operator
Thank you. Our next question comes from the line of Kelly Motta with KBW. Please go ahead.
Kelly Motta
Hey guys. Thanks. Good afternoon. Thanks for the question. I thought maybe if we could start off with your M&A commentary. You mentioned continued appetite in the three-state footprint. The environment has been really slow recently. Just wondering if you – what you think it’s going to take to get M&A starting back up again. Have you also seen kind of the pace of conversation slow or with rates rising and are you seeing any sort of pick back up again?
Jeff Deuel
Well, thanks Kelly for the question. I tend to try and preempt the questions with making a comment, but I think that I can verify what you just stated that things are very quiet and have been for most of the year, much like we have done in the past and all through COVID was to keep tabs on the other bankers, make sure they know what we’re doing that they know that there’s a level of interest in certain of the targets if they’re thinking of doing anything, but it’s remarkably quiet right now. We did just go to the OBA & WBA conference last week in Coeur d’Alene saw everybody again after three years, but that didn’t move anything along necessarily.
So I think things will probably stay quiet for the balance of the year based on what I can see and maybe some general stability or some clarity around the future will get people thinking about what they might want to do. I would’ve thought maybe the threat of recession would maybe cause someone to maybe rethink their strategy, but that too has not happened yet. Fortunately, we’ve had these new teams to focus on for an organic build. So from my vantage point, I think from the team’s vantage point that that undertaking was analogous to a small acquisition and I think it was great that we had the opportunity to spend time on that while things are quiet on the M&A front.
Kelly Motta
Understood. Thanks for entertaining the question. Maybe piggybacking off the new team hires and kind of how that factors into the expense run rate. I think last quarter you said 37 to 37.5 was a good run rate. Does adding four new teams now, how does that change maybe the expense outlook? Does that add to kind of what those expectations had been in the past, or did that factor in continue hiring and building out of teams?
Jeff Deuel
Yes. Adding the teams does come at a cost. So I’ll pass the mic to Don and let him refresh you on the run rate.
Donald Hinson
Kelly with the teams, in addition to some, again, internal compensation projects we have going on or had going on, we’ve implemented now, we’re looking to up our guidance on that to a $38 million to $39 million per quarter as a result. And again, lot happened this last quarter, so we are upping our guidance.
Kelly Motta
Understood. Thanks. And are you continuing to look to add the teams like I know that’s going to – I’m sure factoring into really strong loan growth guidance for next quarter. Is that something you’re continuing to explore and continue to have conversations or do you feel good with the hires you’ve made for now?
Jeff Deuel
I would say, we feel very good about the hires that we have got across in the last quarter. We’ve had them on deck for about two months now. So everybody is finding their way through our processes and procedures. And as we said earlier, starting to develop the pipeline, their own pipelines. There’s potential for more disruption in our footprint. And we’ve historically made the statement that our first choice is to pursue teams that might present themselves as a result of disruption. So I think if the right teams come along with the right cultural fit for us and the right business fit, I think you would see us continue to take advantage of opportunities there.
Kelly Motta
Got it. Last question for me, I was surprised to see the loan yields come in a bit. I understand it was partly PPP and partly non-accrual recovery last quarter. Can you refresh us on how much of your loan book floats and if there’s maybe any benefit of the rate hike that didn’t fully flow through loan yields in your margin this past quarter?
Jeff Deuel
Don…
Donald Hinson
Sure, Kelly. Sure. Yes. And if you – Page 29 of the investor presentation is pretty good on showing the floating rate parts of all of our earning assets. So I think it’s like 23% of our loan book is either LIBOR or prime based. So that’s going to be a help in future quarters. And in addition to our overnight cash position, I would say you probably notice that the originations rates were still in the low-fours. There is a lag effect on rates for new loan originations because the deals start, they got kind of put into place as far as locking in rates, maybe even months in advance. And so there’s probably a quarter or so difference. We’re hoping to see higher rates as we get into future quarters on new loan production in addition to of course having that 23% that’s floating.
So I think we’re going to get some lift going forward. But again, I think the reason it didn’t go up much the last quarter, we did get some lift from the floating, but what we were putting them on at was not much different than what they were coming off at. In fact some of the – what they were coming off at was probably higher than what they were putting on at. So that’s probably the reason.
Kelly Motta
Got it. I appreciate all the time and all the questions. I’ll step back. Thank you very much.
Jeff Deuel
Thank you, Kelly.
Operator
Thank you. [Operator Instructions] Currently, there are no questions waiting at this time. I would like to pass the conference back to the management team for any closing remarks.
Jeff Deuel
Thanks, Bethany. If there is no more questions, we’d be happy to wrap up the quarter’s earnings call. We thank you all for your time and your support and your interest in our ongoing performance and we look forward to talking with many of you in the coming weeks. Thank you and goodbye.
Operator
Thank you. There will be a replay available approximately an hour after the end of today’s call. To access the replay, please dial 1-844-200-6205 and enter the access code 476131. The replay will be available until July 28. That concludes the Heritage Financial Corporation Q2 2022 earnings call. I hope you all enjoy the rest of your day. You may now disconnect your lines.
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