Brian Vance - CEO Don Hinson - CFO Jeff Deuel - President and COO Bryan McDonald - CLO.

Jeff Rulis - D.A. Davidson Jackie Chimera - KBW Tim O'Brien - Sandler.

Ladies and gentlemen good afternoon, thank you for standing by and welcome to The Heritage Financial’s Fourth Quarter and Year Ending Earnings Conference Call. At this time all lines are in a listen-only mode. Later there will be an opportunity for your questions and instructions will be given at that time.

[Operator instructions] As a reminder, today’s conference is being recorded. I would now like to turn the conference over to our host Chief Executive Officer, Mr. Brian Vance. Please go ahead..

Thanks, Tom. I’d like to welcome to all who have called in this morning and to those who may be listening later in the recorded mode. We’re coming to you live from near Seattle, Washington, the home of the defending and contending world champion, Seattle Seahawks.

Attending with me this morning is Don Hinson, our CFO; Jeff Deuel, President and COO and Bryan McDonald, our Chief Lending Officer. Our earnings press release went out this morning and a pre-market release and hopefully you’ve had an opportunity to review the release prior to this call.

And I’d ask as we go through our prepared comments as well as our Q&A later in the session that you’d refer to looking forward-looking statements in the recent press release.

I’ll first start with just few highlights of our fourth quarter, diluted earnings per share were $0.24 for the quarter ended 12/31/14 compared to $0.04 per share for the prior year quarter ended 12/31/13 and $0.23 for the linked quarter ended September 30, 2014.

Heritage declared a cash dividend of $0.10 per common share, an increase of 11.1% from the prior quarter regular cash dividend. Non-covered loan receivables in net of allowance for loan losses increased approximately $61 million or 3% to $2.1 billion at 12/31/14.

Non-maturity deposits increased approximately $56 million or 2.4% to $2.38 billion at 12/31/2014. And finally non-performing non-covered assets increased $6.1 million or 38.5% to $9.7 million at 12/31/2014. Don Hinson will take a few minutes and cover our financial statement of results.

Don?.

Thanks Brian. I’ll start with the balance sheet. Total assets increased only 8.6 million during the quarter but the percentage of higher earning assets increased materially during the quarter.

Total net loans increased $40.8 million and investment securities increased $57.8 million during Q4, these increases were funded primarily by a decrease of $101 million in interest earning deposits.

The increase in the investment portfolio was driven by purchases of $94 million partially offset by $33 million in principal pay downs and maturities and $6 million in sales of securities which resulted in net gain of $33,000.

Non-maturity deposits continued to show growth as they increased $56.8 million during Q4 and approximately $220 million since the Washington Banking merger on May 01.

The increase in non-maturity deposits has been partially offset by decreases in CD account balances, CDs decreased $52.5 million in Q4 and have decreased approximately $114 million since the merger. Net deposit growth since the merger is approximately $106 million.

Moving on to some credit quality metrics, we saw significant improvement in credit quality metrics for the non-covered loan portfolio totaled non-accrual, non-covered loans decreased $4.2 million or 35.6% during Q4 and total non-performing non-covered assets decreased $6.1 million or 38.5% from the prior quarter end.

Non-accrual loans decreased primarily due to $5.6 million of loans that were removed from the non-accrual status as the results are being worked out and or paid off during the quarter. The ratio of our allowance for loan losses on non-covered loans to non-performing loans stands at a very healthy 295%.

Net charge offs on non-covered loans for Q4 were higher than normal but most of these loans are taken against previously known problem loans. Non-covered loan charge offs were offset by equal amount of provision which was primarily for Q4 loan growth.

Net charge offs on covered loans were mostly due to one particularly large loan on which we were able to achieve resolution during the quarter. This one loan represents $1.34 million of $2.08 million in covered loan charge offs for Q4.

As a result of this charge off, indemnification asset was increased by 703,000 the provision for loan losses in the amount of 792,000 was recorded as a result of this charge off.

The total FDIC indemnification asset balance was lower to $1.1 million as of December 31, of this amount approximately $300,000 is related to the 10 year single-family loan loss share agreement and approximately $800,000 is related to the 5 year non-single family loan agreements the last of which will be expiring in July of this year.

Therefore by the end of the third quarter, the $800,000 indemnification asset related to the non-single family loans would have been either used in loss claims with the FDIC or amortized to zero.

Moving on to net interest margin, our net interest margin for Q4 was 4.74%, this is a 42 basis point increase from 4.32 in Q3, the increase is due primarily to a 39 basis point increase and the impact of incremental discount accretion.

The increase in incremental discount accretion was due to significant amount of payoffs and low workouts in Q4 as well as some quarter end adjustments to prior accretion estimates, relating to loans obtained in the Washington Banking Merger.

Recurring value of non-covered acquired portfolio has decreased $68 million in Q4 and recurring value of the covered portfolio is decreased $12 million in Q4 for a total decrease in the quarter portfolio of $80 million in Q4.

We’re estimating that the discount accretion in next couple of quarters will be more than $2 million to $3 million range this estimate of course is subject to the speed of loan payouts within the portfolio. Pre-accretion net interest margin increased slightly to 3.86% in Q4 from 3.83% in Q3.

This increase was due primarily to a 25 basis points increase in yields on taxable securities partially offset by a 4 basis point decrease in pre-accretion loan yields.

Non-interest income decreased $1.6 million during the quarter primarily due to effects of the FDIC indemnification asset as was mentioned in the earnings release a combination of claims relating to loan workouts and valuation adjustments affect balance of indemnification asset in Q4.

All the gains on sale loans 336,000 related to mortgage loan sales and 187,000 related to FDA loan sales. The decrease from the prior quarter was due to a decrease of 186,000 in mortgage loan sale gains.

Probably to touch on non-interest expense as in prior quarters, non-interest expense was impacted by merger related expenses, these expenses totaled approximately $1.7 million during Q4 up from $1.3 million in Q3. A majority of the expenses in Q4 related to severance payments to transitional employees.

We expect to realize substantial portion of our cost savings related to Washington Banking Merger in Q1 of 2015. I’ll hand it over to Bryan McDonald, who will now have a update on loan production..

Thanks Don. During the fourth quarter, the commercial lending teams closed $207.6 million of new loans which is up from a $123.5 million in the third quarter, a $120 million in the second quarter and $100 million on a combined basis by Heritage and Whidbey commercial teams in the first quarter when they operated as separate banks.

Gross non-covered loan totals increased in the quarter by $59.3 million as a result of the strong level of originations.

Commercial team pipelines ended the fourth quarter at $206.5 million which is down from 281 million at the end of the third quarter, the decline was due to the high level of new loans closed in the fourth quarter and is not a result of changes in loan demand.

SBA 7(a) production in the fourth quarter included 13 loans for 6.2 million and we ended the year with 9 million in the SBA 7(a) pipeline. This compares to the third quarter where we closed 16 SBA 7(a) loans for $7.5 million and ended the quarter with $14.8 million in the 7(a) pipeline.

Consumer production remains strong for the fourth quarter with $28 million of new loans closed. The $28 million was comprised of $20 million in dealer volume and $8 million in branch volume. This compares the third quarter with $26.7 million of new consumer loans and the second quarter were $30.4 million of new consumer loans.

The mortgage department closed $30.4 million in new loans in the fourth quarter compared to $27.1 million in the third quarter $26 million in the second quarter and $16.9 million into the first quarter. The mortgage pipeline ended the fourth quarter at $21.1 million down from $26.6 million at the end of third quarter.

I’ll now turn the call to Jeff who has an update on the conversion and merger activities.

Jeff?.

Thanks Bryan. If you recall that we’ve successfully completed the conversion of legacy with these operating platform on to the legacy Heritage DNA core system in early October as originally planned.

As a result of that core conversion and continuing efforts to integrate the two banks you’ll notice that we’re able to reduce FTE from 809 at June 30, 2014 to 748 as of December 31, 2014 contributing to our overall cost saves.

We’re pleased with the results of the core conversion and our integration efforts to-date, while the heavy listing of the conversion is behind us. We are now focused on refining our staffing levels, the back office process.

It is possible that our overall FTE levels may increase slightly over the first half of the year as we adjust staffing metrics from one department to another. But we would expect to see that number trend down again as we approach year end and should come out slightly lower than where it is now.

We also believe we see additional benefits overtime as we’re being to fully utilize the capabilities of the DNA platform across the combined bank.

I think it’s important to note that the increase in loan production in the fourth quarter mentioned by Bryan McDonald together with the non-maturity deposit growth mentioned by Don, -- early indications of the potential combined organization as we continue to untie the two banks.

And I’d like to pass it to Bryan who’d like to finish up with some comments on capital management..

I’ll start with capital management comments and then move into some brief outlook for 2015. Under capital management we’ve declared a $0.10 dividend which is a 25% year-over-year regular dividend increase, it is also roughly in line with our previously stated payout ratio of 35% to 40% assuming merger related expense adjustments.

We continue to believe we’ve flexibility and opportunity for future regular dividend increases as our profitability continues to improve as a result of continuing growth and efficiencies of our recent merger.

Our tangible common equity remains at a healthy 9.7% and our strong TCE level continues to give us flexibility for a variety of growth opportunities as well as other capital management strategies.

Now for few comments and just in terms of an outlook for 2015, we believe our core Puget Sound counties of King, Snohomish and Pierce, economics will continue to improve and we believe this improvement is likely to be sustainable throughout 2015.

While we’re pleased with the overall loan growth in Q4 we continue to see very competitive local lending markets. And with the recent drop in general rate environment we’re experiencing a very competitive commercial lending environment resulting in a much higher commercial real estate refinancing activity.

We hope to achieve non-covered loan growth for 2015 in the 6% to 8% range. We will continue to focus on quality loan growth.

We will also focus more on growing non-interest income through growth than maintaining our current margins and doing so we’ll concentrate our loan growth in short to medium maturity durations so it’s not to take undue future interest rate risk.

We believe we’ve achieved the announced cost savings with the Washington Banking company merger and we’ll continue to focus on improving our various efficiency metrics such as assets, our employee efficiency ratio and overhead ratio.

As Jeff has mentioned we’re pleased with the positive results from our conversion from the legacy with the Island Bank customers and we continue to be pleased with the overall integration of the two organizations. That completes our prepared remarks Tom, and we’ll open the lines for any Q&A that we may have..

Thank you. [Operator Instructions] Our first question today comes from the line of Jeff Rulis representing D.A. Davidson, please go ahead sir..

Question on the sort of the late loan growth that you alluded to.

First, was that -- you get the sense was from a competitor, some of those loans or kind of new demand of current customers or how would you characterize?.

Jeff, this is Bryan McDonald.

It was really across the board, there was no particular competitor situation that drove significant volume and particularly on the construction side where we have some growth, a portion of that was related to closings going back to the second and third quarter where we close the number of larger construction loans and of course in many cases it takes months for those to fund through the borrower equity before they get into the bank that so, no specific place and really a combination of factors going back into the second quarter driving that loan growth..

And as far as late growth, we obviously impacted the pipeline do you think that, that cannibalizes Q1 growth or has that pipeline rebuilt so far in Q1?.

We continue to see a very nice level of lending activity and then the first couple of weeks of January, we already saw the pipeline replenishing itself certainly it’s starting at a lower rate and I’d also add the Q1 typically is not our strongest quarter for loan growth historically and so but I guess the general comment would be we still see strong loan demand although the market is competitive..

And then maybe a last one on the late growth, the average I don’t know if there is average rate of that production but how does that do you think that could translate to some tailwinds on margins into Q1, assuming it was as a higher rate or maybe loosely comment on the rate impact you would expect from that late growth..

Jeff, this is Don. We’re going to I think the rates going on are somewhat lower but again I think that were more leveraged outside I think that the leverages going to help our margin in fact the leverage going to happen late in the quarter.

And so I think that’s going to offset some of the lower rates on the loans and sales some of the loans were actually some tax-exempt loans also they got lower rates but you also get the benefit on the tax side..

That maybe net neutral to margin?.

I think it might be yes..

Okay, and then just a question or two on the cost side.

So, are the merger cost would you anticipate finished here for WBCO?.

Jeff, its Brian. Yes I believe so, there may be a little carry over but I think it will not be significant, it will be very little..

Got it and then as we point to the run rate on expenses then I think Don mentioned we’d substantially get the cost savings in Q1.

So, I guess absent the merger cost is that a decent run rate on non-interest expense?.

I think it’s going to be, our run rate is looking to be less because we have some more employees, the employees, were levels lowered throughout the quarter.

So I don’t think just taking the quarter and introducing it by the merger cost is actually going to be a low enough expense level, should be lower than that, because the lower amount of employees by year ends..

Okay and so if heard Jeff right then if you’re refining those staff levels throughout the year.

I mean you might carry some little higher than possibly if we step down in Q1 we might even see some lower cost towards the back half of the year?.

From an FDE standpoint Jeff I think what we’re looking at is, as we refine and we’re reassessing that 90 days after or 120 days after the conversion.

We may see FDE go up maybe 5 or 10, when I say it’s slightly I mean slightly through the first half and then I think as the first half grows around we’ll start reassessing it and start working towards slightly lower number than where we are now..

Don, did you have a tax rate you expect for 2015?.

Well, I think, obviously it has been very -- I think it’s going probably be in the 29% to 30% range..

Our next question comes from the line of Jack [indiscernible] with KBW. Please go ahead, sir..

I wonder if you could touch a little bit on the great consumer growth that you had in the quarter and just what I'm curious about is that I know about that with more of the consumer lender historically and I'm wondering how much of that growth is from those legacy branches versus how much of it is the successful application to Heritage?.

Jackie, this is Bryan McDonald. The bulk of the growth is on the indirect side, that market has been very strong for us this year the production levels up significantly all year first quarter pre-merger and then it’s just carried on for the residual of the year so it’s primarily in the indirect consumer lending that’s driven the growth..

And I would add to that Jackie, I do think that, now that the conversion is behind us, I like the legacy would be consumer loan origination platform whether it would be on the indirect side or the direct side I think there was something that we didn’t really have perfected well on the legacy Heritage side I would anticipate that we could see some increased growth on a direct side across the legacy Heritage footprint as we move 2015.

So I think we can look for some strong consumer lending growth in total ‘15 it may not equal that of ‘14 because I think indirect side driven by a very high level of auto sales not only just locally but nationally whether or not that continues in ‘15 and that remains to be seen, but overall I think that you’ll continue to see strong consumer loan growth as we move to ‘15..

And then, I have been expecting a seasonal decline in C&I portfolio and that actually bumped up a little bit.

Was there anything unique that happened in the fourth quarter?.

Jackie, this is Bryan McDonald again. No, we continue to add new relationships, we did have about $10 million seasonal decline related to our operation in Central Washington for the ag business in the fourth quarter but that more than made up with new origination volume.

The usage percentage is actually maintains has not changed, so that wasn’t a driver around the growth. So it’s added commercial business in the fourth quarter..

And how is interest, just given recent movements in rates and I think you had mentioned that CRE refinancings could become an issue.

How is that impacting demand just across portfolios?.

I think as we’ve gone through ‘14 we’ve seen our customers doing more borrowing which is obviously our preference versus going out and trying to take a customer from one of our competitors and so that percentage of business coming out of the customer base versus requiring us to take a loan from a competitor and we continue to see our customers doing more business and there has been a fair amount of new construction loans for owner occupied as well as few non-owner occupied projects equipment purchases and other fixed asset purchases.

So we’re seeing loan demand continue to return to the customer base..

Jackie, this is Brian. Just a comment little bit on the CRE growth and I made that comment in my opening remarks about refinancing activity and I think we can expand to just prepayment activity.

I think we saw that in Q3 we certainly saw it in Q4 I think other banks are seeing this as well, I think what’s going on out there is the lower interest rate is driving some refinancing activity in the CRE space.

I see that continuing and of course if it’s one of our loans already we will be very competitive to retain the loan with sometimes when folks are out there with sub-4% fix for 10 it’s a hard one to agree, to keep it with that interest rate duration. The flipside to that I think we see some real estate properties moving.

I think folks are taking money off the table. I think the real estate valuations have come back and they’ve got some nice equities and they’re taking money off the table and selling real estate.

So I think it’s a combination of a lot of things for the last couple of quarters and its likely to continue in ’15 just from the standpoint of an interest rates have gone down more and prospects for lower rates longer certainly appears to be the case..

Okay, and just one quick last one Brian, just on the topic of usage within the commercial portfolio, most of your not most lot of the economies that your footprint touches I read more and more articles about how well the economy is doing so what are you thinking is needed to see those usage rates move up?.

Well, I think it’s just going to take time I mean the usage rate I was just watching here was just under 40% in December actually 39.7 up from 39.5.

I think the proportion of the customer bases is mature with very good equity positions in working capital and after the last downturn, there is still approaching things with less leverage and more liquidity and so I think the answer is just time we do have a strong economy and people are borrowing but it’s still more on a term basis perhaps than just more usage of outlines..

I’d add anecdotally I think also what we see going on is that the improvement we’ve seen in the local markets is more real estate driven than it is just commercial business driven.

I think the commercial business owners have not seen that lift but they certainly have seen some improvement that can be wrong but I don’t think they’ve seen the lift that we’ve seen on the real estate side and so I think our smaller businesses are probably being a little more careful because they’re not seeing that top line revenue line grow a lot yet.

Hopefully that will change and when if it does I think we can see higher utilization rates..

[Operator Instructions] And we’ll go to line of Tim O'Brien representing Sandler, please go ahead..

Good morning, most of my questions have been answered I just ask Brian, can you tell me what unfunded commitments are for construction at year end versus at the start of that third quarter, right at the start of the fourth quarter?.

I don’t have that with me here Tim, but we can give you a call back with it..

Yeah, or email that'd be great.

And then Brian are there any markets real estate markets that you think either from an industrial standpoint, or retailers or such and I'll say Seattle proper Kings county or maybe peers are getting pretty hot with valuations now perhaps in Portland, can you characterize any markets are avoiding?.

Sure, I think I continue to talk about the core Puget Sound markets which I defined as Snohomish, Everett, Seattle and Pierce, Tacoma those three counties are certainly the strongest counties within our entire footprint and I make everything centered around Seattle and the ripple of that Boeings activities, Amazon all of the high tech industries and so we certainly have seen real estate values rebound nicely.

I always I’ve been thinking for the last 6 to 12 months that we’re may be seeing a bubble at some point in time especially on the multifamily side, there is a lot of multifamily activity but there is a lot of folks I think just changing lifestyles and not wanting to tie to mortgages and homes when they can qualify but there is a tremendous amount of I’ll say high rise apartment condo complex is being built in Seattle for folks downtown Seattle for folks that want to leave downtown.

So, I don’t see that necessarily as a concern at this point and when I look at other sectors whether to be let’s say the commercial sector, warehouse sector, I don’t know that we’ve seen anything that concerns us from a valuation perspective. I think that we’ve got a keep our eyes to the cap rates and watch those cap rates as we move forward.

As my remark earlier, we’re going to maintain a loan quality and we’re going to watch for bubbles, unreasonable cap rates et cetera but on our footprint I don’t really see things that necessarily concerns me you mentioned Portland, I’m going to candidly say that, that’s not a big part of our operating footprint today.

So, it’s not something that we’re focused on. I think we will continue to focus future loan growth in this three county core market that we’re operating in..

And then last question for Don. Don, obviously data processing costs are pretty elevated in the conversion quarter in such. Can you give any sort of sense of kind of a range of how they might sell a lot here, it's a pretty important piece of it. You must have some decent sense of how that's going to play out.

You're starting in the first quarter or even in the second quarter?.

It’s going to be lower but again there is some cost in there I think if I go back to our, look our quick we’re talking here on the, how much we had 212,000. So there is not a lot I would say there maybe a little bit more savings than what’s in those merger related cost but for the most part we’re one system for the quarter, so that’s. .

Maybe like third quarter number of 7.5 million or something it might settle to, is it going to be a little higher than that even?.

Well, again I think if you look at the fourth quarter when we were actually pretty much for whole quarter are combined system and then obviously we have some one-times expenses we listed in there I don’t think it’s going to materially changed from that a lot I think it might be somewhat less because of some items are clearing up it was a lot.

If we had merger related items it would have been shown in that table. So I don’t think there is a lot of less than what runway would give you..

To add to that Tim I think really if you’re looking at run rates the bulk of the improvement is obviously going to come out of the total company benefits and remember that quarter there were a number of folks that left employment as we work through the quarter even in the December. As we’ve noted there were some severance cost et cetera.

So I think the bulk of the improvements going to come out of compensation employee I think a little bit will come out of maybe other expense. But I think data-process in the some of those others are likely to remain fairly flat. .

Okay. And then I guess just to follow-up then on that.

I mean looking back at, where you guys, how you thought cost savings might play out with the combined companies when the deals were announced? How is that fading with what you're actually seeing and how would you compare those remarks back than where we are today?.

Sure. To remind everybody we announced 20% cost saves would be non-interest expense or 10% combined because the two companies were identical in size and identical in non-interest expense.

So just using the 10% combined cost saves and looking at what we’ve accomplished, we’re going to exceed that 10% it’s not going to be by a wide margin but we believe that it will be a few points over that 10% as it stands now and I think that’s important to remember because as we move through ‘15 there is still some more expense reduction that we’re going to get that’s not going to be a big number, but the expense saves we’ve already build into the process is likely to grow as we move through ‘15..

And we’ll go to line of Jeff Rulis with D.A. Davidson. Please go ahead sir..

Sorry, one more expense question but different angle. On the merchant card sale, you mentioned you’d expect revenues to cut in half.

Is there a related expense drop expected?.

No, there is not, it’s on the revenue side. It’s just how we’re doing, it’s just the process, it’s not necessarily any of our expenses related to it..

Mr. Vance there are no other questions queuing up at this time..

If there are no further questions I appreciate everybody’s continued interest in our company and I know that few of us are going to be making the rounds at investor conferences over the next few weeks so I’m sure we may run into some of you and appreciate your interest today. And go Hawks..

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