Heritage Financial Corp (HFWA) 2020 Q4 法說會逐字稿

Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial Earnings Conference Call. (Operator Instructions) As a reminder, your call today is being recorded.

I'll now turn the conference call over to your host, President and CEO, Jeff Deuel. Please go ahead.

Thank you, Alan. Welcome to all who called in and those who may listen later. This is Jeff Deuel, CEO of Heritage. Attending with me are Don Hinson, our Chief Financial Officer; Bryan McDonald, our Chief Operating Officer; and Tony Chalfant, our Chief Credit Officer. Our earnings release went out this morning, pre-market, and hopefully you have had the opportunity to review it prior to this call. We have also posted an updated fourth quarter investor presentation on our Investor Relations portion of our website. Please refer to the forward-looking statements in the press release.

We are pleased with our performance in the fourth quarter. We continue to operate the bank effectively with the majority of our branch lobbies opened by appointment only, and about 40% of our workforce still working remotely. Despite the challenging circumstances, we've adapted and this operating model is working for us and actually has helped us identify some new areas for efficiencies and increased productivity. We have reached something of a plateau with regard to the reopening of the economy in the 2 states where we operate. The major metro areas are still generally operating in a more limited fashion; that would be downtown Seattle, Downtown Portland. But there is more normal activity when you get outside the core metro areas, which is where Heritage has a pretty significant presence.

We expect the region will remain at the current levels of activity until we see more relief from the vaccines, which is coming out slowly. In the fourth quarter, we announced the consolidation and closure of 9 branches or 15% of our branch footprint. One branch closed in October and 8 branch locations closed in mid-January. We did this to continue improving operating efficiency, and it is in line with the changes happening in the banking industry overall. Of the 9 locations, 5 were owned real estate, 1 of which was sold prior to year-end and 2 are already under contract to be sold. You will also have noticed the gain on sale from a property sold in the fourth quarter, which was a property that formerly housed a branch in some of our back-office operations. We expect to see incremental benefits and efficiencies beginning in Q1 2021.

We continue to focus on digital enhancements to improve customer experience and improve efficiency of our back-office operations. That focus started with the new treasury management platform we call Heritage Direct, which was implemented in phases starting in the spring of 2020.

We continue to focus on development and implementation of a commercial loan -- an automated commercial loan origination system and an automated customer relationship management platform that will allow us to do more with the same workforce and also provide a better experience for our customers. We expect to realize benefits from these initiatives over the next few years. And borrowing a phrase from the aviation industry, which has a long history in the Pacific Northwest, we are moving away from visual navigation to navigation through instrumentation.

We'll now move on to Don Hinson who will take a few minutes to cover our financial results, including some color on our core operating metrics.

Thank you, Jeff. As reported in our earnings release, we recognized earnings of $0.66 per share in Q4 compared to $0.46 in Q3. We also reported a $3.3 million or 15% increase in our pretax pre-provision income from the prior quarter. Before digging further into the income statement, I'm going to start by reviewing the balance sheet. Starting with loans. Our loans receivable decreased $198 million from Q3. This decrease was due mostly to $153 million decrease in SBA PPP loans as a result of the forgiveness process.

In addition, we had decreases of $32 million in consumer loans and $17 million in C&I loans. The decrease in C&I loan balances was due mostly to a decrease of $13 million in 2 large relationships. Consumer loan balances are decreasing primarily due to indirect auto loans, which we ceased originating early in 2020. Indirect auto loans decreased $27 million in Q4, and we expect that will approximate the runoff in future quarters. Bryan McDonald will discuss loan production in a few minutes.

Deposits decreased $91 million in Q4 due primarily to a decrease of $96 million in 1 public deposit relationship. This was an investment account for the public entity as opposed to an operating account, and we decided not to pay the higher rate due to our significant liquidity position. Moving on to the allowance for credit losses. In Q4, we recognized a reversal of provision for credit losses in the amount of $3.1 million compared to a provision of $2.7 million in Q3, which favorably impacted pretax income by $5.9 million quarter-over-quarter. The total reversal of provision for Q4 included a reversal of provision for unfunded commitments in the amount of $341,000.

At the end of Q4, the allowance for credit losses on loans was 1.57%, which is unchanged from the percentage at the end of Q3. Excluding PPP loans, which are guaranteed and not provided for, the allowance for credit losses on loans was 1.87% at December 31, a decrease from 1.93% at September 30. This lower allowance percentage was due to a decrease in allowances on individually evaluated loans as well as slight improvements in the economic forecast from the prior quarter. Due to various factors, including government stimulus programs, charge-offs in 2020 have been lower than we originally thought they would be at the end -- at the beginning of the pandemic. Net charge-offs for 2020 were only 7 basis points.

The magnitude of future provisions will be dependent on a combination of factors, including economic forecasts, charge-off experience and loan growth. Tony Chalfant will discuss credit quality metrics in a few minutes. Our net interest margin increased 15 basis points in Q4. This occurred mostly due to the 21 basis point impact of PPP loan forgiveness where the deferred fees were accelerated at the time of forgiveness. The impact of PPP forgiveness was partially offset by lower yields on the investment portfolio and on the loan portfolio ex-PPP as well as a higher percentage of lower-yielding overnight cash balances.

Partially offsetting the lower asset yields was a decrease in the cost of deposits. Deposit cost decreased in all categories with a total cost of deposits decreasing to 14 basis points in Q4, or a reduction of 5 basis points from Q3 levels. Noninterest income increased $3.1 million from the prior quarter due mostly to a combination of various items, including a death benefit on BOLI policies, net gains in the sale of branch buildings, fees realized from the sale of our trust operations and increases in gains on sale of mortgage loans.

Noninterest expense increased $2.5 million in the prior quarter due mostly to $1.4 million of costs recognized in Q4 in association with the branch consolidation plan that Jeff previously mentioned. In addition to severance costs recognized for branch consolidation, compensation expense also increased due to increases in estimated incentive payouts as a result of improved performance metrics. We expect to continue to see elevated expense levels in both compensation and professional services as a result of efforts surrounding PPP loan forgiveness and a new round of PPP loans.

I wanted to briefly discuss our effective tax rate. 2020 was the last year we were able to utilize the 7-year new market tax credit. The amount of the tax credit for 2020 was $1.5 million. Although we continue to seek to add other tax credits, we do expect our effective tax rate to increase in 2021 as a result of the expiration of the current new market tax credit.

And finally, moving on to capital. All of our regulatory capital ratios increased from the prior quarter and are strongly above well capitalized classification thresholds. Our TCE ratio was 8.9% at December 31 and is 10% when you remove the impact of the PPP loans. Based on our strong capital position and improved outlook on the future, we are lifting our self-imposed suspension of our stock repurchase program.

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

Thank you, Don. Regarding credit quality, our net charge-offs for the fourth quarter were $363,000. This was primarily attributed to the partial charge-off of a commercial construction loan that was impacted by cost overruns and construction delays. Net charge-offs for the year totaled $3.2 million, which was very similar to what we experienced in 2019. We also experienced an increase in nonaccrual and potential problem loans due to the continuing impacts of COVID-19. Nonaccrual loans increased by $5.5 million during the fourth quarter and ended the year at 1.3% of loans receivable. The increase in nonaccrual loans was primarily the result of 2 commercial and industrial relationships and 2 owner-occupied commercial real estate loans that have all had some impact from the COVID-19 pandemic.

Potential problem loans increased by $45.2 million during the fourth quarter, or 28.3%. The majority of this increase was from loans impacted by COVID-19 related issues that continue to demonstrate weakness. Almost all of these additions were downgraded to special mention, with only a small portion downgraded to substandard. Regarding loan modification, under the CARES Act and related regulations, in 2020 the bank provided loan modifications on 2,041 loans with total balances of approximately $667 million, using March 31 numbers, for borrowers that were impacted by COVID-19 related issues.

As of December 31, there were 175 loans totaling approximately $70 million that remained in a payment modification status. Using outstanding loan balances, the majority of these borrowers are making interest-only payments versus a full deferral of their loan payments. Of these remaining borrowers, 35% or approximately $25 million are in the hotel and restaurant categories, the industries most impacted by COVID-19.

In summary, approximately 88% of the borrowers that received a payment deferral COVID modification in 2020, were no longer in a COVID status -- a modification status as of December 31, and of the borrowers that remained in a modification status at year-end, 50.3% are designated as troubled debt restructures and 50% -- 57% are risk rated substandard. The bank is following regulatory guidance, and has designated loans as troubled debt restructures when the total of payment deferral modifications exceeds 180 days. We've provided additional detail on loan modifications on Page 20 of the investor presentation.

Bryan McDonald will now have an update on loan production and our SBA PPP activity.

Thanks, Tony. I'm going to provide detail on our fourth quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $140 million in new loan commitments, down from $181 million last quarter and down from $306 million closed in the fourth quarter of 2019. The commercial loan pipeline ended the fourth quarter at $413 million, up 7% from $386 million last quarter and up from $390 million at the end of the fourth quarter of 2019. New loan demand continues to be negatively impacted by COVID-19, but our bankers report increased discussions with customers on capital projects, expansion plans and bank transitions, causing us to be cautiously optimistic this will translate into a higher loan volume in the second half of the year.

Loans, excluding SBA PPP balances, decreased $45 million during the fourth quarter due to the relatively low new loan production and increased prepayment activity. Payoffs and prepaids were $176 million for the quarter, up from $131 million last quarter and $96 million in the second quarter. For the full year, loans were up a modest $61.7 million or 1.8%, excluding the impact of PPP and indirect lending, which was discontinued in the first quarter of 2020.

Consumer production was $18 million for the fourth quarter, down from $19 million last quarter and down from $49 million in the fourth quarter of 2019. The decline versus 2019 was due to the discontinuation of our consumer indirect lending business during the first quarter of 2020.

Moving to interest rates. Our average fourth quarter interest rate for new commercial loans, excluding PPP loans, was 3.32%, which is down 23 basis points from 3.55% last quarter. In addition, the average fourth quarter rate for all new loans, excluding PPP loans, was 3.42%, down 22 basis points from 3.64% last quarter.

The mortgage department closed $57 million of new loans in the fourth quarter of 2020, compared to $49 million closed in the third quarter and $52 million in the fourth quarter of 2019. The mortgage pipeline ended the quarter at $33 million versus $52 million in Q3 and $15 million in the fourth quarter of 2019. Refinances made up 69% of the pipeline at quarter end.

Moving on to SBA PPP, starting with loan forgiveness on round 1. We continue taking forgiveness applications in waves for our 4,600-plus round 1 PPP customers. The process is running smoothly, but labor-intensive for those loans over $150,000 in size. We anticipate having the majority of our customers invited to apply by the end of April, and the bulk of round 1 PPP forgiveness applications processed by the end of August.

As everyone is aware, the recent stimulus bill included a second round of PPP. SBA opened to accept applications for banks our size on Tuesday, January 19. We were through the peak of our customer applications by the 21st and opened to accept applications from prospects on the 23rd. Through yesterday, we had 2,100 applications, including those in process, $180 million approved through the SBA and $116 million closed and funded. It's unclear at this point as to how many of the pending applications will move all the way through the lending process. However, assuming 50% of the applications not yet approved by the SBA end up progressing to closing, the total volume of round 2 PPP would be in the $250 million to $300 million range.

I'll now turn the call back to Jeff.

Thanks, Bryan. As I mentioned earlier, we're pleased with our performance to date. Our primary concerns remain with borrowers in the high-risk loan categories, which is not news. These businesses make up the vast majority of the increase in nonaccrual and potential problem loan categories. As in the past, you will see these loan categories ebb and flow quarter-to-quarter as we work with our customers. I encourage you to focus on net credit losses, which historically have been relatively low due to our conservative risk profile and much-discussed concentration management system.

While we are feeling better about the big picture at this point, we are still facing several uncertainties around the vaccine, the economy, the political climate and ongoing social unrest in several of our core metro markets, which could potentially impact our performance. However, for now, we're comfortable with where we sit, and we believe the impact of the pandemic on our loan portfolio will be much more subdued than we originally anticipated. As Don mentioned earlier, we believe our current capital levels are adequate and our robust liquidity provides us with a solid foundation to address challenges and also take advantage of opportunities. We are focused on what we can control, including managing risk, managing expenses, and continuing to develop the technology we need to deliver consistent long-term performance.

That is the conclusion of our prepared comments. So Alan, we are ready to open up the call now and welcome questions that any of you may have.

(Operator Instructions) Our first question will come from the line of Matthew Clark with Piper Sandler.

Maybe if we could just start on the expense run rate and kind of the technology reinvestment needs and the things you're working on this year. I guess, how should we think about the puts and takes around expenses?

Matt, let me give you some color on that. I will say just as a reminder, our Q4 expense run rate tends to be the lowest of the year, and our Q1 tends to be the highest. So it basically goes -- first couple of quarters are higher and then they tend to drop down based off various factors. So speaking of that, we actually have some -- obviously, a lot of exit costs associated with branches in Q4. We also are going to have some savings associated with not having those branches in Q1, mostly realized in Q2. We do have a few exit costs left. But we are -- we do have technology. We also are having some expenses associated with the forgiveness for the new originations of PPP. So those are going to -- there'll be some expenses in there.

So looking ahead, I foresee that because of these expenses we didn't have last Q1, that we're -- but having savings at the same time, that we're probably going to be kind of close to where we were last Q1, kind of net out, but still will depend on various factors as far as how much we do have to spend on the PPP process.

And just to clarify, I mean, you're talking about that $37 million run rate a year ago, excluding exit costs, which we'd likely back out?

Well, I'm saying that, all net, we'll be closer to the next -- to Q1 of last year than we were to Q4 or even Q3 of this year. So net it all out.

Got it. Okay. And then just on the opportunities to hire teams in your markets, it sounds like there's a fair amount of disruption in the Northwest. Are you in talks with anyone these days? Are you at a point where you're close to hiring some bankers here in the near term?

Well, Matt, you know from prior conversations that we're always open to consider high-performing teams joining us, and we've successfully done that both in Seattle and in Portland. We're typically always in conversations with folks in the industry, whether they be people maybe looking for a change or, quite frankly, other banks. So it's really up to us to determine the timing because up til now, we've been reluctant to bring on teams with all the uncertainty around us. And I think it's possible that we could do something this year, but we haven't been rushing to do it because we're waiting for everything to settle down first.

Okay. And then just on the M&A side of the equation, can you give us an update there? Have conversations started to pick up more meaningfully? And do you expect to get something done this year?

Much like everybody else, we are hopeful that there will be more activity as the year progresses, probably more in the latter part of the year. But we've been pretty diligent throughout the whole COVID experience, keeping in contact with people we know in the industry so they can see how we're doing and what we're up to, and that has served us well over the past couple of years in terms of keeping people informed so that if they decide to do something, we get a call. I think the conversations may have gotten a little bit more interesting in the last month, but I wouldn't say it's significantly different.

Okay. And then, Don, can you just give us the remaining amount of net -- net PPP fees left from round 1?

Yes. I think it's a little over $15 million.

We'll go next to the line of Jeff Rulis with D.A. Davidson.

A question for -- I wanted to follow up Don's to clarify the expense number. You're saying that that's closer to Q1 of '20 versus Q4 of '20? And then given what you said typically, so confirm your balance there? And then the trend of that would be, it falls off from the Q1 level of '21 through the balance of '21?

Yes. Jeff, I'll try to clarify that. So yes, I expect expenses to be closer to Q1 of '20 for the next couple of quarters based off the costs. And hopefully, we can continue to work that down over time. But I do expect it to be closer to Q1, based off offsetting factors that always hit us in the first part of the year.

Yes. Got it. Trying to strip out the -- some of the exit costs, but that's helpful.

There can be factors to name, but I'm just trying to give you an overview of that, so...

No, I appreciate it, Don. Don, the branch closures of what you've identified or what you've closed, probably a smattering of decisions there. But I don't know if there was a guiding -- do you base that judgment off of profitability, metro versus rural, proximity to the other branches. Was there some themes of what you're looking to pull from the network?

I think what you primarily saw us do, Jeff, was rationalize branches that were close to other -- it was based on proximity for the most part. And I think that is partially a result of some of the new view we have had this year into our customers' activities. A lot of people obviously signed up for online and mobile, and we're realizing that the number of branches is -- does not need to be as robust as it used to be. And we'll continue to look at the rest of the footprint. And I suspect, over time, you will see us continue to chip away at the big broader footprint that we have, where it makes sense.

Okay. And Jeff, the reinstatement of the buyback, does that -- has that darkened the view of sort of M&A prospects? Or is it simply just a -- we've got to keep that tool back up, and, accordingly, use it. Just I guess we shouldn't overreact to that being reinstated. It's more a product of some comfortability about the macro environment?

Yes. Yes. I think that was a good way of putting it. It's just one of the tools we have; and in the right circumstances, we want to be able to use it, and -- if it makes sense. But no, I don't think you should overreact to us announcing that we're bringing it back.

Don, anything you want to add to that?

No, I think you covered that.

Okay. And last one, just maybe for Bryan. It seems you've got a little kind of creep in the NPA figure, but with the recapture, my guess is those that migrated to nonaccrual were certainly on watch and reserved for. And just understanding that the direction of the reserve is more indicative of growing comfort than maybe watching the NPA level. Anything you could expand on kind of reserve levels and additional release into '21?

Don, maybe you want to take the reserve piece and then maybe Tony comment on the credit quality.

I apologize. I mean Tony, sorry about that.

No problem.

Yes. So I'll talk about the provisioning. As I mentioned, Jeff, it's just what -- there will be a lot of factors, including what kind of loan growth we have. But as far as the current increase in NPAs, even though they were added, there wasn't a required provisioning for those because of the collateral valuation on them. So we felt pretty good about not adding any for those. Obviously, we're going to watch carefully the -- what's -- goes on in the economy, especially our industries that are -- have more challenges than others. We thought there was more favorable outlook quarter-over-quarter. We did not -- at the current level of what's going on in the local economy, we just didn't feel like we could release too much.

Obviously, there some had to happen because of, if nothing else, the loan balances, but we didn't feel it was right to release too much of that currently. But I can see that if we continue not to have charge-offs, at some point that will -- the provisioning will have to come back in. But it's hard to say whether the charge-offs are just postponed or they're really not going to be nearly as high as we initially thought. So -- but it's kind of early in the game.

And I don't know if Tony, you want to add any more to that.

Yes. Thanks, Don. Yes, Jeff, just to answer to your question. I think if I don't answer it correctly, let me know, but -- or what you're looking for. But I feel like we -- the bank had pretty much the -- identified all the credits that were really at risk, all the loans that were really at risk, by the end of the second quarter. And so really, the second half of the year has been largely just managing that portfolio and watching the more impacted borrowers migrate to the worst risk rating categories, including, of course, special mention, substandard and then obviously looking at nonaccrual and TDR situations. So we feel pretty good at the end of the year that that portfolio is identified, segmented properly. And as we move forward, it's just a matter of managing a -- maybe a much smaller population of loans than we might originally thought we'd have earlier in 2020.

(Operator Instructions) We'll go to the line of Jackie Bohlen with KBW.

I apologize if this is a little bit technical of a question, but what kind of an effect did the decline in indirect auto have on the release this quarter from the provision standpoint? Just broadly, if it was a factor in that.

Jackie, you can just probably take the provision expense we have. I don't think it was -- it might have a higher percentage. I don't remember off the top of my head, what percentage we're applying to indirect auto, probably higher than what we've gotten there at 2% because it's much higher than, say, commercial real estate. I don't remember exactly what it was. But if you take that decline in balance of $27 million and take it, say, it might be 3%, might be closer to what we allow for that, that might be an impact on that.

Okay. I mean, I guess where I'm going just broadly is wondering if part of that portfolio being in runoff mode, absent any other changes, is going to cause the ratio itself to kind of gradually trickle down as the risk profile shifts a little bit.

I would say marginally, but we're also down to about $200 million for the whole portfolio. So it will have less and less of an impact.

Okay. Okay. And then the 2 C&I loans that were called out as having the decline in the quarter, the 2 significant relationships. Was that intentional or was that driven by something else -- intentional on your part.

Tony, you may want to take that one.

Yes. Actually, Bryan, you might have a better idea on that. That's the ones that paid off in the quarter that -- the larger relationships.

Yes. Jackie, this is Bryan. We did have elevated payoffs and pay downs in the quarter. And both of the large ones I'm thinking of were both business sales, but we also had some refis, which wasn't those 2, but that was the other big driver kind of coming back in, perhaps, just as the economy -- as people have a little better visibility. Of course, rates are very low. So we didn't see a lot of refi activity, obviously, in Q2 or Q3, but we saw more in Q4 and then a resumption of some of the business sales we were seeing last year.

Okay. And I mean, just based on the pipeline numbers you gave, it sounds like, setting payoffs aside from an origination standpoint, it sounds like you're fairly well situated into the year. And then maybe more optimistic for a pickup as things start to open up, hopefully, in the latter half? Is that a good characterization?

That's true. Right now, of course, we've got everyone focused on getting their customers through PPP, although that was a much shorter, I guess, window of time where we are fully focused on it. We're already well over the high point, and this week closing a lot of loans, but by the time we get into next week, I think we won't be back to normal because we'll still be working on it, but much less of a focus. And with the vaccine rollout and the economy continuing to open up, we do see the second half of the year with a lot more potential.

Jackie, you know that you will probably never hear us use the term exuberance in terms of our future outlook. But I do want to remind everybody that under the overlay of COVID-19, the region was performing at a pretty high level before the pandemic, and there's still a lot of activity going on underneath the surface. We just saw a new article about the Seattle market being in the top 10 most active economies in the country. I realize that we're overshadowed with the pandemic. But when that starts to -- we start to be relieved of that pressure, there's a lot of potential in this region. And remember that in the metro markets, we're still relatively new.

So there's still a lot of work to be done there. And also not to forget when we did PPP 1, we got a good chunk of new prospects out of that, and they're still coming across the transom. It's not been a quick close because of everyone being remote and being distracted with where they are. So -- and on top of that, we've got Microsoft and Amazon are still building and buying all over the footprint, so -- and housing prices are still very strong here, you know that. So I think all of those things point to that cautious optimism that Bryan talked about, in the second half of the year if we get the vaccine going in the right direction.

And Jackie, this is Don. Just while others were talking, I did check, and about $500,000 of the release this quarter was due to the decline in indirect auto balances.

We have no further questions in queue at this time.

Well, if there's no more questions, then we'll wrap up this quarter's earnings call. Thank you all for participating. We appreciate your support and your interest, and I think we're going to see or at least talk with some of you in the coming weeks. So looking forward to that. And thank you very much for joining us.

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