Heritage Financial Corp (HFWA) 2025 Q4 法說會逐字稿

Hello, everyone, and welcome to the Heritage Financial 2025 Q4 earnings call. My name is Emily and I will be coordinating your call today. (Operator Instructions). I would now like to turn the call over to Bryan McDonald, President and CEO to begin. Please go ahead.

Thank you, Emily. Welcome and good morning to everyone who called in and those who may listen later. This is Bryan McDonald, CEO of Heritage Financial. Attending with me are Donald Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer.

Our fourth quarter earnings release went out this morning pre-market and hopefully you've had the opportunity to review it prior to the call.

In addition to the earnings release, we 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 this presentation during the call.

As a reminder, during this call, we may make forward-looking statements which are subject to economic and other factors. Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within the earnings release and the Investor Presentation.

Our improving net interest margin and a shift in our loan mix benefiting the provision expense drove earnings higher in the fourth quarter.

On an adjusted basis, diluted earnings per share was up 18% versus last quarter and up 29% versus the fourth quarter of 2024 and on the same adjusted basis, our ROA improved to 1.29% versus 0.99% in the fourth quarter of 2024.

We now have regulatory and shareholder approval for the pending merger with Olympic Bancorp and plan to close at the end of January. Their addition to the Heritage franchise will add to the profitability of our operations and better position our company for growth in the Puget Sound market.

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

Thank you Bryan. 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 the prior period comparisons will be with the third quarter of 2025.

Starting with the balance sheet, total loan balances increased $14 million in Q4, yields on the loan portfolio were 5.54%, which is one basis point higher than Q3. The positive impact of new loans being originated at higher rates and adjustable rate loans repricing higher was partially offset by the impact of three rate cuts over the last four months of the year.

Bryan McDonald will have an update on loan production and yields in a few minutes.

Total deposits increased to $63 million in Q4. This increase was due primarily to a $100 million increase in interest-bearing demand deposits. The cost of bringing demand deposits decreased to 1.83% from 1.89% in the prior quarter.

As a result of the rate cuts in Q4, we expect to see continued decreases in the cost of deposits. Investment balances decreased $31 million due primarily to expected principal cash flows on the portfolio. The yield on their investment portfolio decreased 9 basis points to 3.26% for Q4 compared to 3.35% in Q3.

This decrease was partially due to a bond called in Q3 that provided approximately 4 basis points of additional accretion income back quarter and partially due to the runoff of higher yielding bonds without replacement of those balances at current market rates.

The cash flows provided by the investment portfolio, as well as growth in deposits was used to pay down borrowings during the quarter. Borrowing balances decreased to $20 million at year end from $138 million at the end of Q3. The remaining balances all mature in 2026.

Moving on to the income statement, net interest income increased $1 million or 1.7% from the prior quarter due primarily to a higher net interest margin. The net interest margin increased to 3.72% from 3.64% in the prior quarter and from 3.36% in the fourth quarter of 2024.

We recognized a reversal of provision for credit losses in the amount of 814,000 in Q4. This reversal was due primarily to a change in the mix of the loan portfolio. During Q4, commercial construction loans decreased while permanent commercial real estate loan balances increased.

We consider construction loans to have an inherently higher credit risk component and provided a much higher allowance on those loans. Therefore, the reallocation of those balances resulted in the allowance decrease to 1.10% in Q4 from 1.13% in Q3.

In addition, net charge-offs remain at very low levels. Tony will have additional information on credit quality metrics in a few moments. Non-interest expense decreased $132,000 from the prior quarter due mostly to lower merger related expenses.

Comp and benefits expense was hired due primarily to increased incentive compensation accrual and not due to additional employees. We continue to manage our employee levels carefully as shown by decreases in average FTE from both the prior quarter and the same quarter in the prior year.

And finally moving on to capital, all of our regulatory capital ratios remain comfortably above well capitalized thresholds, and our TCE ratio was 10.1%, up from 9.8% in the prior quarter. We were inactive in both lost trades on investment and stock buybacks in Q4.

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

Thank you, Don. I'm pleased to report that we ended the year with strong credit quality across all segments of our loan portfolio.

Non accrual loans total $21 million at year end and we do not hold any OREO. This represents 0.44% of total loans and compares to 0.37% at the end of the third quarter.

The increase was primarily attributed to three non-owners occupied CRE loans that were moved to non-accrual status due to their delinquency. These loans are all well secured and are expected to pay off from either sale or refinance of the underlying properties with no anticipated loss.

Total non-accrual additions of $4.4 million were partially offset by $1.1 million in payoffs or paydowns within our non accrual loan portfolio we have just over $2.4 million in government guarantees.

Non-performing loans were stable during the quarter with a 0.44% of total loans matching the ratio at the end of the third quarter. In addition to non-accrual loans over 90 days and still accruing was limited to one small residential mortgage loan with a balance of $194,000.

Criticized loans moved lower during the quarter, however, we did see an increase in our substandard loans.

Criticized loans total just under $188 million at year end, declining by $6.6 million during the quarter. While special mention loans were lowered by 29%, some were downgraded to substandard, resulting in a 24% increase in that risk category during the quarter.

The largest contributor to the increase came from the downgrade of two C&I relationships totaling just under $30 million. Partially offsetting the downgrades was the resolution of a long-term problem loan workout for a non-owner occupied CRE loan resulting in a full payoff of $15.6 million.

While we are closely watching this increase in substandard loans, they remain at manageable levels at 2.44% of total loans and in line with our longer-term historical performance.

Page 19 in our Investor Presentation provides more detail on the composition of our criticized loans and reflects the stability we've seen over the past two years. During the quarter we experienced total charge-offs of $640,000 primarily in our commercial loan portfolio.

The losses were partially offset by $159,000 in recoveries, leading to net charge-offs of 481,000 for the quarter.

For the full year total net charge-offs were just under $1.4 million or 0.03% of total loans. This compares favorably to our 2024 performance where net charge-offs were just over $2.5 million, representing 0.06% of total loans.

We are pleased that our early identification and proactive management of problem credits has led to another year of exceptionally low loan losses. The correlation between these credit management practices and our low level of historical loan losses is demonstrated on page 20 in the Investor Presentation.

Overall, we remain pleased with the credit quality of our loan portfolio at year end. We believe our consistent and disciplined approach to credit underwriting and concentration management will continue to generate strong credit quality performance in a wide range of economic conditions.

I will now turn the call over to Bryan for an update on our production.

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

For the quarter, our commercial teams closed $254 million in new loan commitments, down from $317 million last quarter and down from $316 million closed in the fourth quarter of 2024.

Please refer to page 13 in the Investor Presentation for additional detail on new originated loans over the past five quarters.

The commercial loan pipeline ended the fourth quarter at $468 million, down from $511 million last quarter and up modestly from $452 million at the end of the fourth quarter of 2024. As anticipated, loan balances were fairly flat quarter over quarter with a $14 million increase in the quarter.

Total new loan production of $271 million was largely offset with elevated payoffs and prepaids. Looking year over year, prepayments and payoffs were $208 million higher than the prior year, and net advances on loans have swung from a positive $153 million last year to a negative $81 million in 2025.

Please see slides 13 and 16 of the Investor Presentation for further detail on the change in loans during the quarter.

Looking ahead to 2026, we expect to resume loan growth at more historical levels as we are through the period of known elevated loan payoffs, and we expect net advances to move back to a positive position.

Deposits increased $63 million during the quarter and were up $236 million for the year. The deposit pipeline ended the quarter at $108 million compared to $149 million in the third quarter, and average balances on new deposit accounts opened during the quarter are estimated at $43 million compared to $40 million in the third quarter.

Moving to interest rates, our average fourth quarter interest rate for new commercial loans was 6.56%, which is down 11 basis points from the 6.67% average for last quarter. In addition, the fourth quarter rate for all new loans was 6.43%, down 28 basis points from 6.71% last quarter.

In closing, as mentioned earlier, we are pleased with our solid performance in the fourth quarter.

Our assets continue to reprice upward and deposit growth has allowed us to pay down borrowings. These factors drove our net interest income up a million dollars versus last quarter and up $4.6 million versus the fourth quarter of 2024.

The combination with Olympic Bank Corp and its subsidiary Kitsap Bank will add to this positive momentum. We look forward to having the exceptional bankers at Kitsap join the Heritage Bank family and are excited about what we can accomplish together.

Overall, we believe we are well positioned to navigate what is ahead and to take advantage of various opportunities to continue to grow the bank.

With that said, Emily, we can now open the line for questions from call attendees.

(Operator Instructions) Jeff Rulis, DA Davidson.

Thanks, good morning. I appreciate, slide 20, good morning. The, slide 28, I think outlines a pretty good outlook for your adjustable-rate opportunity. Looks like within the next year, almost a 200 basis points, potential there if for price. I mean maybe Don if you could kind of. Unpack the margin outlook given looks like you got some earning asset for price opportunities still to come.

Yeah thanks Jeff there's. If we look back and see what happened, we this last quarter we had. Well, we've had about three rate cuts in the last four months of the year, and we were still able to slightly grow our, loan yields in Q4.

So this is where the in a, in a quarter where we have rate cuts, we're going to have this balancing where we're repricing our, adjust rate loans higher, putting on new loans at higher rates, but the adjustable rate loans or the, floating rate loans will be, obviously repriced down those tied to prime or silver.

So, kind of even for, this last quarter if we have quarters where we, do not have rate cuts, we expect, more improved, improvement in, loan yields and then on the deposit side.

The cuts help us, speed up I guess, our deposit betas but at the same time I think because we have rate cuts at the end of the year, I think we'll continue to see some improvement in our, on the cost. So overall I think that and this is all without the merger, right?

It's, that's, going to occur so just on the legacy heritage side we expect to see margin improvement continue, over the next year or two.

Got it, and if I could take that step of incorporating Olympic, look like, their margin was a little bit lower, but a smaller balance sheet and adding accretion, any thoughts on that kind of the blended if we look at legacy upward trending, role in Olympic, any broad level thoughts on, the consolidated margin.

Well, and I'm going to preface this if I get questions about the this year as far as the combined because obviously we have You know we have some fair value work to do once the deal closes and we will get that done in this quarter, and so we've got some initial estimates from that we did in our due diligence. I don't think they've changed a whole lot.

But, I will just preface that that, it's a little, less precise than we would might normally be on this, but you know their, I think their loan portfolio will probably reprice with yields up in the, low sixes, so if you think about that, and then their deposits are already, I think they're over 20 basis points lower than our cost of deposits and then the invest portfolio should be price probably up into the.

The low to mid, fours, which I think they're a three or a little under on theirs currently so I think that we're going to get a nice bump in margin, where we could potentially, get near that 4% range by the by the end of the year.

Appreciate it, Don. Thanks, and maybe if I hopped over to, well, but Bryan, I appreciate the commentary on maybe getting back to normal on, with payoffs maybe subsiding a bit is that historical rate kind of a mid to to high single-digit? Is that what we could expect absent the balances from Olympic?

Yeah Jeff, it would just add to the, yes, so the short answer is yes, but would add to that looking at the pipeline, at the end of the fourth quarter, the $468 million and we have good visibility near term so I would say low single-digits is our estimate, kind of Q1, and then I would move that to upper single-digits, based on what we're seeing. From the customer base and loan demand, heading into 2026, which is, the pipeline's been increasing, since year end, so that's our, thought based on what we're seeing today.

Okay, so I, Slow rate and then and then it's accelerating as we go over the course of the year. Appreciate it, thanks I will step back.

Matthew Clark, Piper Sandler.

Hi, this is [Adam Kroll] on for Matthew Clark, and thanks for taking my questions.

Sure.

Yeah, so Bryan, I think last quarter you mentioned having a few chunky loans you expected to pay off in the fourth quarter. Just wanted to check if any of those got pushed to the first quarter and just digging more into the loan growth guide in '26, what industries or geographies do you expect to drive that loan growth?

Yeah, so the, I would say the bulk of the payoffs we're anticipating did come through, the payoffs were, payoffs and prepays for a little over $170 million for the quarter, which was the highest quarter, of the year, and so for the total, year it was more like, $540 million, $550 million, around $45 million a month.

We think that's, going to, moderate at least based on our current visibility, potentially a third less, and then, as I said in my comments, last year we had this last year being $222,025, we had net advances on loans fall $81 million, versus 2024 where they were up $153 million, so we've cycled through that and I think we should also see. Net advances, move up modestly in 2026.

So, potentially a third less payoff prepay volume and then not the you know negative drag from net advances that we had in 2025 so that's kind of what's happened in '25 and you know it has played out substantially based on you know our expectations as we came into '25.

Got it. No, that's great to hear. And maybe switching to expenses, how are you thinking about operating expense growth both on a legacy heritage basis for '26 and just maybe what's a good starting point for pro forma 2Q expense run rate?

Sure, Don, you want to take that?

Yeah, I think we're combining this there's so much, like noise going on, I think maybe we'll just maybe just talk about what kind of we're expecting, we are expecting. Approximately $20 million-$21 million of bridge related expenses, so.

But removing those, I think you know starting in Q2 and the other thing we have going on here is our conversion is not expected to take place until sometime in September so we're keeping you know a large amount of the employees that at some point will be will.

Be gone by the end of the year, but we'll keep them through, Q3, because we'll be on two separate systems, then we'll have a reduction of employees, after that, but the probably the run rate for Q2 and Q3 will probably be in the [$56s], some, probably somewhere in the [$56] range, maybe a little [$56, $57].

So that will be for Q2, Q3, and then we'll have some, we'll get more of our cost savings in Q4 and the core will probably be down more in the in the $54 million range after that.

Got it. And then just last one for me, I'd like to hear your updated thoughts and, crossing the $10 billion in asset threshold and just maybe what inning you're in in terms of making the necessary investments to cross that $10 billion mark?

Bryan, you want to take that one or?

Yeah, sure, I'll take that one. Let me take the second part of your question first just in terms of preparedness. We did extensive planning back in 2023 when we were about $7.7 billion in assets, felt like we had, three or four years, but we wanted to be, very clear on what, we needed to do so we put together a pretty detailed plan, met with our regulators and a variety of other, parties.

And so we've been making progress on that plan since then, with our, deposit outflows we had in 2023, we felt like we had a a little bit, of additional time, and, so anyway, we've been making progress on that and have a good view and, what the requirements are in terms of when we cross the [$10], our focus now is on. Integrating, Olympic and making sure that, all aspects of that, go as planned on an organic basis, we're several years out, from crossing the $10 billion, so, that's how we're looking at it right now, executing on the plan to be ready, but still seeing ourselves a ways off from crossing it.

Got it, thanks for taking my questions.

Sure.

Jackson Laurent, Stephens Inc.

Hey, good morning, this is Jackson on for [Andrew Terrell].

Morning, Jackson.

Morning, if I could just start out on the margin, more specifically loan yields, you guys already touched on the fixed repricing benefits to low yields a little bit earlier. I was just wondering if you could kind of give some color on what you're seeing on the competition front in your markets. It looked like origination yield stepped down a little bit quarter over quarter.

Yeah, sure, Jackson, I'll take that. So on commercial loans, the new loan production went on at [$556] during the quarter and then in total it was [$643], so that that was down a bit over Q3. Some of that's due to, the drop in short-term rates, any variable rate loans we have just kind of naturally are going to come on at lower levels, and then, the rest is just driven really off of what the federal home loan bank, particularly the five year index does, during the quarter, from just purely a competitive standpoint.

It continues to be a really competitive market, for, the clients that that we're going after and particularly so you know if it's a new relationship to the bank where there's you know you know maybe several banks you know competing for that opportunity although I would say that's not significantly different you know than it than it normally is so we're not we're not seeing you know necessarily any outsized you know competition is just always competitive for that for the type of clients we're going after.

Got it. That's helpful. Thank you. And then just on the deposit cost front, sounded like maybe some positive carry forward into the into the first quarter. Just wondering last quarter you guys talked about around a billion dollars of exception price deposits that were sitting around a 3% rate just wondering where that bucket is, and where that, is priced today, and also just how much room you guys have left on the deposit repricing front.

Sure, yeah, we have, we're still at about the same level of exception price, but the cost overall cost at your end, I think we're down to about I think we're maybe [$270].

At this point, so, and we still have, there's some other still other we still have about $100 million of, floating rate public deposits, that would come down if there were rate cuts. We didn't experience all that impact because again we had a rate cut in December, so we'll that'll help out and of course the CD rates I think keep coming down so.

Our average rate of, CDs, core CDs is like [$360] I think we'll keep working those down I think the current our current highest rate is like [$330], so, there, there's definitely, we're expecting, cost to keep coming down, our December cost was lower than for the quarter by about 4 basis points, so that's just again another sign that that's going to keep coming down a little bit.

Got it. That's helpful. Thank you. And then just last one for me, I know we talked about like uses of capital being on hold until the closing of the Olympic transaction, but with a clear line of sight to deal close later this month and capital building nicely, I was just wondering if you could kind of update us on capital priorities in 2026.

Sure, Don, you want to take that?

Sure. Well, again, the first one was just, closing the transaction and, that we'll use about again we've we've mentioned this before about 100 basis points of capital so.

That's the that's the most important use of capital this year we will look into, other uses as we do more planning and as we get through again the fair value so we really know what our balance sheet looks like, we'll, we can take, I guess more steps to manage it to the levels that we want to be at, so we're there could be some buybacks we have about $800,000 shares left in our current repurchase program. There's always a chance we could do more lost trades, but we're not planning any at this point, but there's a chance we could do.

I would say we could do buybacks we find that the the dilution is less but maybe the accretion is less from the deal, then maybe buybacks makes sense to to kind of offset that so we'll we'll kind of we're we're working on that now again after the deal closes at the end of the month, we'll definitely be looking carefully at that.

Got it thank you that's helpful thank you for taking the questions.

Thank you, Jackson.

Liam Coohill, Raymond James.

Hey, good morning everyone. It's Liam for [David Feaster].

Morning, ma'am.

So you know I want to touch on some of the impressive interest-bearing demand deposit growth you saw in the quarter. Could you maybe discuss some of the initiatives that you've been using to see success there? Is it mostly granular wins across the franchise?

Yeah, it is it's really a continuation of what we've been doing, throughout the bank's history, just, relationship banking high service quality, delivery, and then we added, significantly to our, deposit sales team.

You know over the last several years and so we continue to see, new relationships coming in from, the investments we've made, with our deposit teams and, slide 11 in the in the Investor deck, has that that detail, but back in 2022, we added three teams that year and two third of that group were, deposit generating.

Staff and then of course, several new locations, both in Oregon and then, Boise and then also Spokane, so it is a continuation of what you know the bank's always focused on which is those relationship clients but we have benefited pretty significantly from both, the new teams as well as, our existing efforts in that area.

Oh great, thank you for the color. And just one more for me, on the credit side, I'm just curious if there's any underlying trends or industries that you're watching more closely and on a couple C&I downgrades in the quarter, were those idiosyncratic or were there any commonalities?

Thank you.

Sure, Tony, you want to take that one?

Yeah, sure. Good morning, Liam. I, there was really no correlation between those two deals. They're kind of separate industries, and I guess, the big question is were, was there any tie into tariffs or things like that, and I would say no. So not really, anything that I can really point out to, obviously both being in C&I category, jumps out, but, I think it was just that was just more. You know timing than anything else and doesn't really reflect anything that we're watching more closely in the portfolio.

Well I appreciate the color. I'll step back.

Okay, thanks Liam.

Kelly Motta, KBW.

Hey, good afternoon, thanks for the question. I guess as we as we look ahead, your efficiency ratio for the past couple years has hovered in that mid 60% range, you did a bunch of things with the securities loss trades and such and expenses, in order to kind of mitigate some profitability headwinds now with the increased scale from Olympic.

I'm wondering how you're thinking about. How that helps with generating, perhaps better efficiency ahead is that, is that a way you're thinking about it? Just interested in thoughts here since it seems like the growth and margin picture is shaping up quite nicely. Thank you.

Yeah, maybe Kelly, thanks for the question. I'll have Don, start and then maybe I'll provide some comments after Don, shares his thoughts.

Okay thanks Bryan. Yeah, we're going to, I think that just the overall. Are you talking about the efficiency ratio itself, Kelly, or are you just talking about operations?

I was, I was speaking specifically with the the efficiency, but, I don't know how you necessarily think about it, so if it's easier to talk about it, just is operational efficiency in general that's okay too.

Okay, well, I will just touch on the, obviously we, we're going to get, overall efficiencies, with the between the two organizations, our efficiency ratio will, continue to go down over time. But I will say also that I think it would be mostly driven on the revenue side, as opposed to the expense side, but we are looking at again, trying to keep our expense base at a good level, but Bryan, I don't know if you want to talk more about what you see in the overall efficiencies of the organization.

Yeah, I would just add a little bit on to what Don said, if you look at the trajectory of heritage kind of independent of the combination with Olympic, we've had a big increase in our margin, year over year. So, Q4 last year was [$336] and [$372], and, Don had mentioned in terms of answering.

You know Jeff Ruis' question, we see, potentially get that, margin, potentially up in the four range, within the not too distant future. So that's the revenue driver.

Beyond that, the combination with Olympic is bringing a significant amount of low cost deposits, there's a little bit of a recap on slide 6 of the Investor Presentation, on, the merger with Olympic, and, one of the bullet points highlights their cost of deposits at [$102]. It doesn't note their loan deposit ratio, but it's in the mid-sixties and ours, of course is just over 80, so. There's potential.

Significant potential upside, just some moderate additional leveraging, in the loans over the next few years that will give us room to drive that efficiency ratio lower. So those are my thoughts obviously we'll be continuing to focus on ways that we can continue to scale the company without you know adding significant cost we can be continuing to focus on you know our expense run run rates.

But if you look at kind of what's happening on the loan repricing side and the asset repricing you know the addition of the kits that balance sheet, mark to market on the asset side. You know it's a pretty good outlook and then of course if you add the additional leveraging there's a lot of additional potential beyond that.

Got it. Maybe last question for me. I realized this is a little early to be asking this question, but with Olympic on board, I'm just wondering if there's been any updated, M&A conversations, knowing that you've been, more recently active here. Thank you.

Sure, we're really focused on, making sure that, we get the, combination with Olympic, successfully integrated, and that's definitely our number one priority here in 2026, we at the same time we have, continued to be active in conversations just as, we always do.

So that if, another bank, within our footprint makes the decision that they want to partner with somebody that, we're a known party to them and hope to be considered if that, was the case, so really no change from our, past conversations we're continuing to have them. The only nuance which I just added is, we're very focused on making sure that we get kids that integrated, over additional M&A.

Got it thanks so much I'll step back.

Okay, thanks Kelly.

Thank you. At this time, we have not received any further questions, and so I will hand the call back over to Bryan for closing remarks.

Okay, if there are no more questions, then we'll wrap up this quarter's earnings call. We thank you for your time, your support, and your interest in our ongoing performance, and we look forward to talking with many of you over the coming weeks. Goodbye.

Thank you all for joining us today. This concludes our call and you may now disconnect your lines.