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CALL PARTICIPANTS
- Chief Executive Officer — Bryan D. McDonald
- Chief Financial Officer — Donald J. Hinson
- Chief Credit Officer — Anthony W. Chalfant
TAKEAWAYS
- Adjusted Earnings Per Share — Increased 8.2% sequentially and 17.8% year over year, reflecting improving profitability.
- Total Loan Balances — Rose by $10 million, though elevated payoffs and prepayments tempered net growth.
- Loan Yields — Loan portfolio yield reached 5.50%, up 5 basis points from the prior quarter, driven by higher origination rates and loan repricing.
- Total Deposits — Fell by $60.9 million due to seasonal tax payment outflows, although average total deposits increased by $35.4 million, marking five consecutive quarters of average growth.
- Cost of Interest‑Bearing Deposits — Rose to 1.94% from 1.92%; management does not expect a reversal absent future Fed rate cuts.
- Investment Securities — Balance declined by $67.6 million, with a $6.9 million pretax loss on the sale of $91.6 million in securities as part of a strategic repositioning.
- Net Interest Income — Rose by $1.3 million, or 2.4% sequentially, attributable to higher net interest margin and more business days.
- Net Interest Margin (NIM) — Improved to 3.51% versus 3.44% last quarter, due to higher yields on loans and investments.
- Provision for Credit Losses — Recorded $956,000, driven by loan growth and net charge-offs.
- Noninterest Expense — Decreased by $298,000, primarily from reduced benefit costs, payroll taxes, and vendor expenses, partly offset by higher professional services fees.
- Share Repurchases — Bought back 193,700 shares for $4.5 million, with 797,000 shares remaining under the current plan at quarter end.
- Tangible Common Equity (TCE) Ratio — Ended at 9.4%, up from 9.3% last quarter.
- Nonaccrual Loans — Increased to $9.9 million, or 0.21% of total loans, compared to 0.09% last quarter, mainly from a $6 million multifamily construction loan and a downgraded $1.7 million C&I loan.
- Nonperforming Loans — Rose to 0.39% of total loans, up from 0.09% last quarter, reflecting a shift toward normalized credit conditions.
- Government Guarantees on Nonaccruals — $2.3 million in guarantees are tied to the nonaccrual portfolio.
- Criticized Loans — Totaled $214 million, up $35.8 million, with the increase mainly in substandard credits, including a $14.7 million CRE loan and two owner‑occupied CRE loans recently downgraded for cash flow issues.
- Net Charge‑Offs — Totaled $494,000, representing 0.03% of total loans annualized, below last year’s full‑year rate of 0.06%.
- New Commercial Loan Commitments — Achieved $248 million, up from $183 million last quarter; the commercial loan pipeline grew to $473 million.
- Average Rate on New Commercial Loans — Stood at 6.55%, down 28 basis points sequentially; for all new loans, the rate was 6.58%, down 31 basis points.
- Deposit Pipeline — Ended at $132 million, with new account average balances rising to $72 million compared to $54 million in the prior quarter.
- June 30 Spot Deposit Rate — Ended at 1.92%; June NIM reached 3.58%, reflecting continued margin expansion.
- Management Guidance — Expects quarterly noninterest expenses in the $41 million‑$42 million range for the remainder of the year.
- Investment Securities Earn‑Back — CFO Hinson reported a projected three‑year earn‑back for the Q2 securities loss trade, with an estimated pretax benefit of $2.3 million.
- Outlook on Loan Growth — Management projects relatively flat loan balances in Q3 due to construction loan paydowns, with growth resuming afterward as payoffs normalize.
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RISKS
- Chief Credit Officer Chalfant highlighted, “some concern with the increase in nonperforming and substandard loans this quarter,” suggesting normalization toward historical credit trends.
- Nonperforming loans increased to 0.39% of total loans, up from 0.09% last quarter, primarily due to larger multifamily and C&I loan additions to nonaccrual status.
- Criticized loans increased by $35.8 million, driven mostly by downgrades of several larger relationships and cash flow difficulties in key commercial real estate segments.
SUMMARY
Heritage Financial Corporation (HFWA +7.04%) reported sequential earnings growth, with management attributing higher profitability to an improved net interest margin and disciplined expense management. Strategic repositioning of investment securities resulted in a $6.9 million pretax loss, but is expected to deliver a three-year earn-back and future net interest income benefits. Credit metrics indicated an uptick in nonaccrual and substandard loans, which management framed as normalization rather than heightened risk, alongside a modest increase in criticized assets. Robust new loan origination and rising average deposit balances signaled underlying business momentum, although competitive pressures are reflected in slightly moderating loan rates.
- Quarter-end deposit pipeline contracted to $132 million, though the average size of new deposit accounts rose substantially, potentially enhancing funding mix quality.
- CFO Hinson stated, “Although we may see decreases in costs in certain deposit categories such as CDs, we don’t expect overall decreases in the cost of interest-bearing deposits absent further rate cuts by the Fed.”
- Capital remains substantially above well-capitalized thresholds, enabling continued share repurchases and selective balance sheet repositioning initiatives.
- Management expects flat loan volumes in the short term due to construction portfolio run-off, with growth projected to resume post-Q3.
- Expansion activities, including a fully staffed construction team and a new Spokane office, are meeting year-end targets and may prompt consideration of further hiring or lift-outs if market opportunities align.
INDUSTRY GLOSSARY
- Nonaccrual Loans: Loans on which the bank has stopped accruing interest income because of borrower payment delinquency or doubt about full collectibility.
- Criticized Loans: Loans assigned lower internal credit ratings (‘special mention’ or ‘substandard’) due to increased credit risk or underwriting concerns.
- OREO: Other Real Estate Owned; property acquired by a bank through foreclosure or similar proceedings.
- Tangible Common Equity Ratio (TCE Ratio): A measure of a bank’s core equity capital relative to its tangible assets, used to assess capital strength.
Full Conference Call Transcript
Bryan D. McDonald: Thank you, Emily. Welcome, and good morning to everyone who called in or those who may listen later. This is Bryan McDonald, CEO of Heritage Financial. Attending with me are Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer. Our second quarter earnings release went out this morning premarket, and hopefully, you have 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 corporate website, which includes more detail on our deposits, loan portfolio, liquidity and credit quality. We will reference this presentation during the call.
Improving net interest margin and tight controls on noninterest expense growth continued to incrementally drive earnings higher in the second quarter. On an adjusted basis, earnings per share were up 8.2% versus last quarter and up 17.8% versus the second quarter of 2024. We are optimistic these trends will continue, and combined with prudent risk management, will provide progressively higher profitability as we finish out 2025. We will now move to Don, who will take a few minutes to cover our financial results.
Donald J. Hinson: Thank you, Bryan. 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 2025. Starting with the balance sheet. Total loan balances increased $10 million in Q2 as loan originations increased from Q1, but payoffs and prepayments remain elevated. Yields on loan portfolio were 5.50%, which is 5 basis points higher than Q1. This was due primarily to new loans being originated at higher rates and adjustable rate loans repricing higher. Bryan McDonald will have an update on loan production and yields in a few minutes.
Total deposits decreased $60.9 million in Q2 due to the seasonal decline that occurred in April related to tax payments. However, average total deposits increased $35.4 million from the prior quarter. This marks the fifth consecutive quarter of us showing an increase in average total deposit balances. The cost of interest-bearing deposits increased to 1.94% from 1.92% in the prior quarter. Although we may see decreases in costs in certain deposit categories such as CDs, we don’t expect overall decreases in the cost of interest-bearing deposits absent further rate cuts by the Fed. Investment balances decreased $67.6 million, partially due to a loss trade executed during the quarter.
A pretax loss of $6.9 million was recognized on the sale of $91.6 million of securities. These sales were part of a strategic repositioning of our balance sheet. A portion of the proceeds was reinvested in $56.4 million of securities and the remaining proceeds were used for other balance sheet initiatives such as the funding of higher-yielding loans. Moving on to the income statement. Net interest income increased $1.3 million or 2.4% from the prior quarter due to a combination of a higher net interest margin and more days in Q2 compared to the prior quarter. The net interest margin increased to 3.51% from 3.44% in the prior quarter due primarily to increases in loan and investment portfolio yields.
We recognized a provision for credit losses in the amount of $956,000 during the quarter due partially to loan growth and partially to net charge-offs. Tony will have additional information on credit quality metrics in a few moments. Noninterest expense decreased $298,000 from the prior quarter due mostly to lower benefit costs and payroll taxes as well as lower data processing vendor costs. These decreases were partially offset by higher professional services expense, which is partially related to achieving the lower vendor costs. We continue to guide in the $41 million to $42 million range for quarterly noninterest expenses this year. And finally, moving on to capital.
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