Brian Vance - CEO Don Hinson - CFO Bryan McDonald - Chief Lending Officer Jeff Deuel - EVP.

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

Welcome to the Heritage Financial First Quarter Earnings Release. [Operator Instructions]. I would now like to turn the conference over to your host, CEO, Brian Vance..

Thank you, Lois. I'd like to welcome all who have called into the call this morning and those who may listen in later on a recorded mode. Attending with me in Olympia this morning is Don Hinson, our CFO and Bryan McDonald, Chief Lending Officer.

Jeff Deuel is on the road, but he has also called into the call and will be a part of the presentation and available for Q&A later. Our Earnings Release went out this morning. Hopefully you've had a -- pre-market -- and hopefully you've had an opportunity to review it prior to the call.

As I always say, please refer to the forward-looking statement in that press release as we go through the prepared remarks, as well as addressing any Q&A following our prepared remarks. I'll start with some highlights of our first quarter.

Diluted earnings per share, per common share, were $0.32 for the quarter ended March 31, 2015, compared to $0.16 for the prior-year quarter ended March 31, 2014 and $0.24 for the linked quarter ended December 31, 2014.

Return on average assets increased to 1.15% for the quarter ended March 31, compared to 0.83% for the linked quarter ended December 31. Return on average tangible common equity increased 11.98% for the quarter ended March 31, compared to 8.85% for the quarter ended 12/31.

Heritage declared at a cash dividend of $0.11 per common share, an increase of 10% from the $0.10 per common share for the cash dividend paid at quarter ended March 31, 2015. Non-covered loan receivables net of allowance for loan loss increased $45.7 million or 2.2% or 8.8% on an annualized basis, to $2.15 billion at March 31.

Non-maturity deposits increased $41.3 million or 1.7%, for the quarter or 6.8% annualized, to $2.42 billion at March 31. I'd like to turn the call over to Don Hinson who will go through a few items from our financial statements, balance sheet and income statement.

Don?.

Thanks, Bryan. I'll start with the balance sheet. Total assets increased only $1.6 million during the quarter, but the percentage of higher earning assets increased more substantially during the quarter. Total net loans increased $37.2 million and investments increased $4.1 million during Q1.

These increases were funded primarily by a decrease of $41.6 million in cash and cash equivalents. The increase in the investment portfolio was driven by purchases of $56 million, partially offset by $29 million in principal paydowns and maturities and $24 million in sales of securities which resulted in a net gain of $544,000.

Non-maturity deposits continued to show growth as they increased $41.3 million during Q1. The increase in non-maturity deposits was partially offset by a decrease in CD account balances in the amount of $35.2 million in Q1.

We expect the decrease in CD balances to slow in the future since most of the higher paying CDs from the FDIC-acquired banks have since matured. As part of our stock repurchase plan, in Q1 we repurchased 137,000 shares at an average price of $16.10. We still have 1.375 million shares remaining to repurchase under the current plan.

Moving on to some credit quality metrics. We continue to see overall improvement in the credit quality metrics for the non-covered loan portfolio. Total non-accrual, non-covered assets decreased $914,000 or 9.4%, during Q1. This decrease was mostly due to a combination of sales and valuation adjustments on the non-covered other real estate owned.

Our ratio of allowance for loan losses on the non-covered loans to non-covered, non-performing loans stands at a very healthy 299%. In addition, non-performing, non-covered assets to total non-covered assets improved to 0.26% as of March 31 from 0.29% as of December 31. The net interest margin for Q1 was 4.31%.

This is a 43-basis-point decrease from 4.74% in Q4 of 2014. The decrease is due primarily to a 44 basis-point decrease and the impact of incremental discount accretion.

As a reminder, incremental discount accretion in Q4 2014 was elevated due to a significant amount of payoffs and loan workouts, as well as some quarter-end adjustments to prior accretion estimates relating to the loans obtained in the Washington bank merger.

The carrying value of non-covered acquired portfolios decreased $55.3 million in Q1 and the carrying value of the covered acquired portfolios decreased $8.6 million in Q1 for a total decrease in acquired portfolios of $63.9 million in Q1. Pre-accretion net interest margin increased slightly to 3.87% for Q1 from 3.86% in Q4 of the prior year.

This increase was due primarily to the continued leveraging of the balance sheet, partially offset by a 12-basis-point decrease in pre-accretion loan yields.

Non-interest income increased $4.4 million from the prior quarter due to the effects of the FDIC indemnification asset, the gain on the sale of the merchant car portfolio and the increases in gains on sales of loans and investments.

We continued to expect to see lower levels of indemnification asset amortization, since the asset has decreased to $692,000 at March 31 from $1.1 million at December 31. Of the gain on sale of loans, $600,000 related to mortgage loan sales and $535,000 related to SBA loan sales.

Unlike prior quarters, non-interest expense was impacted very little by merger-related expenses. Expenses related to other real estate owned was elevated above historical levels due to a combination of valuation adjustments in the amount of $330,000 and net loss on sale of properties in the amount of $70,000.

I'll now hand it over to Bryan McDonald who will have an update on loan production..

Thanks, Don. During the first quarter the commercial lending teams closed $131.6 million of new loans which is up from the $100 million closed by Heritage and would be commercial teams in the first quarter of 2014, pre-merger, when they operated as separate banks, but down from the $207.6 million of new loans closed in the fourth quarter of 2014.

Gross non-covered loan totals increased in the quarter by $45.7 million as a result of the strong level of origination. Commercial team pipelines ended the first quarter at $296.7 million, reflecting a rebuilding from the $206.5 million pipeline level we had at year end 2014.

Loan demand from our customer base and new opportunities in the market continued to improve. And at the same time, the competitive environment in the market continues to intensify. Considering all factors, we're pleased with our commercial loan pipeline heading into the second quarter.

Line utilization at the end of the quarter was just over 38% which is consistent with the utilization rate we saw all of last year. The average interest rate for the new commercial loans booked during the quarter was 4.05%. SBA production in the first quarter included 11 loans for $6.29 million and the pipeline ended the quarter at $12.6 million.

This compares to the fourth quarter where we closed 13 SBA 7(a) loans for $6.2 million and ended the quarter with $9 million in the SBA pipeline. Consumer production remains strong for the first quarter with $30.62 million in new loans closed. The $30.62 million was comprised of $23.1 million in dealer volume and $7.52 million in branch volume.

This compares to the fourth quarter of 2014 with $28 million of new consumer loans.

The mortgage department closed $34.5 million in new loans in the first quarter, compared to $30.4 million in new loans in the fourth quarter of 2014, $27.1 million in the third quarter of 2014, $26 million in the second quarter of 2014 and $16.9 million for the first quarter of 2014.

The mortgage pipeline ended the first quarter at $40.4 million, up from $21.2 million at the end of 2014. The increase in the mortgage pipeline is being driven by increasing refinance volume due to low interest rates and increases in home purchase and construction activity.

The current pipeline is comprised of 52% refinance loans, 33% purchase loans and 15% construction loans. This compares to our 2014 pipeline where purchase business averaged 55%, but on a smaller pipeline. I'll now turn the call to Jeff Deuel who will have an update on conversion and merger activities.

Jeff?.

Thanks, Brian. With the conversation and the subsequent post conversion efforts essentially completed in the fourth quarter of last year, we've been fully focused on the integration process with good results.

The various bank platforms for the combined bank have settled into a more normal routine and our managers are focused on streamlining and tightening processes in all areas.

It's important to note that our team has been fully engaged with back-to-back conversions for the past two years and up until now, we have not had time to deploy all the benefits of the new operating system. We're now in a position to begin deploying those benefits. In the press release, I mentioned we're strengthening our cross-selling framework.

In addition to communication and training around our ancillary products, we're also in the process of deploying a robust automated referral system to track and monitor all referrals between business lines to help support the pull-through rate. This is a good example of just one of the benefits of the new system.

As planned, we continue to add lenders across the footprint and we continue to drive product implementation, including cash management, wealth management, mortgage and consumer lending. We're really excited to see the results of the first quarter.

While we're seeing ongoing payoffs resulting from the low-rate environment and stiff competition for loans, we're gratified to see the strong loan growth and the deposit growth rates which highlight the potential of the combined bank. We can feel the momentum building inside the organization as the year progresses.

Brian will now have an update on capital management as well as some closing comments..

Thanks, Jeff. First, starting with capital management. As stated earlier, we've declared an $0.11 dividend which is a 10% increase over Q4's dividend and comfortably in the range of our previously stated range of 35% to 40% payout ratio.

Also as Don stated earlier, we did repurchase 137,000 shares during the quarter which essentially offset the annually historical stock grants. We will continue to analyze stock repurchases on an opportunistic basis. Our TCE remains at a healthy -- our tangible common equity -- remains at a healthy 10.0%.

And our strong TCE level continues to give us flexibility for a variety of growth opportunities as well as other capital management strategies. I'll close by just having a few comments on our outlook for the balance of 2015.

As we have stated for the last few quarters, we believe our core Puget Sound counties of King, Snohomish and Pierce continue to improve and we believe this improvement is likely to be sustainable throughout at least 2015. We were pleased with our loan growth in Q1.

However, we continue to see a high level of prepayment activity that is likely to persist as commercial real estate values continue to improve and sellers re-enter the market at attractive valuations. We continue to feel optimistic that non-covered loan growth for 2015 will be in the 6% to 8% range and Q1 annualized slightly exceeds that range.

As was noted earlier, even though our non-accretive net interest margin rose slightly, our non-accretive yields on our loans dropped 12 basis points on a linked quarter basis.

This is consistent with our strategy of focusing on leveraging our balance sheet and growing net interest income even if it means our net interest margin may drop going forward. In doing so, we will continue to focus on high-quality loan growth without taking undue interest rate risk.

As Q1 expense rates are substantially free from merger-related expenses, we believe we have achieved our announced cost saves from our merger with Washington Banking company.

Additionally, we believe there are additional incremental cost saves that will be achieved over the next several quarters as we continue to fine-tune contractual agreements and operational efficiencies.

As Jeff has mentioned, we continue to be pleased with the positive results from our ongoing integration from our merger with Washington Banking company and we believe we will continue to see synergy improvements at all levels going forward. I would welcome any questions you may have.

And once again would refer you to the forward-looking statements in our press release, as we answer any of these questions. Lois, if you would like to open the line for questions, we would appreciate it..

[Operator Instructions]. Our first question is from Jeff Rulis from D.A. Davidson. Please go ahead..

Brian, on topic of cost, seemed like you alluded to that there was some merger costs in the quarter, but maybe pretty modest.

Do you have a number on that?.

It's a little less than $200,000 for the quarter..

Got it. So Brian, on the bigger picture of the cost front, I guess, we're coupling together.

Sounds like it's more revenue synergies going forward that's going to drive efficiency, but if we focus on the cost side is there -- if you look at the $26 million base this quarter, can you improve upon the cost side? Or maybe if you could talk about revenue versus cost going forward..

Well, yes, Jeff, as we all know, the efficiency ratio is two components; one is revenue and one is expense. I think that, hopefully, we can continue to improve on both which will continue to improve efficiency ratio. We've consistently been giving guidance for efficiency ratio in the mid-60% range.

We realize there were some one-offs on the revenue side in Q1 that won't repeat in Q2, but I do think that there are some potential for increased revenues.

I think we're seeing, as Brian mentioned, increased activity in the mortgage banking area which results in non-interest income gains from loan-sale gains, as well as some continued gains on the SBA loan-sale side.

On the expense side, as I indicated, I think the expense saves are going to be incremental as we move forward and it's going to be over the next several quarters. We do see some opportunities from some contract renegotiations and just process improvement.

But I also think it's important on the expense side to note that we do have, as a part of our active strategy is to grow out our lending base and especially in King County. So to the extent that we have success there, that's going to add incrementally to the cost structure. So we're going to reduce it some and add to it.

So it's going to be hard to sort it out. I think from a bigger picture point of view, I do think that we can continue to show slight improvement to the overall operating efficiencies, whether they come from the income side or the expense side and to get really closer to that mid-60 range on the efficiency ratio side..

And maybe lastly, on the net charge-off front, do you get the sense that you're kind of moving through some things that are a little chunky in nature and that I guess you'd think maybe going forward -- actually as the balance shrinks as well -- but you think that net charge-off balance should come down? And then I guess secondarily, if loan growth maybe doesn't keep the pace of Q1 as you're suggesting, maybe you could comment on the provisioning level given the credit and the growth outlook..

Sure. Q1's losses were a little higher than we had hoped for or had anticipated. I think just managing the loan portfolio in general, whether it's loan growth or provision or losses, is never an incremental straight line. There is always some one-offs as we move forward. I think Q1 -- I'm hoping that it was a bit of a one-off on the credit-loss side.

And I think the provision, obviously, will be affected by loss and will be affected by loan growth and certainly, provision in Q1 was partially due to a strong growth quarter. We will continue to provide for loan growth going forward. I think that's important to remember.

But generally speaking, I want to believe that Q1 was a little bit of a one-off on the loss side, but predicting losses are kind of hard to do. But going forward, I think we're going to still remain overall high-quality portfolio..

Thank you. Our next question is from the line of Jackie Chimera with KBW. Please go ahead..

Just wanted to know -- sorry, wasn't expecting to be second.

As I'm looking at the growth in the mortgage banking and the SBA that you had in the quarter, how much of that was driven by environment? And how much of that is synergy driven?.

A combination. The SBA business is something that we targeted last fall for growth and expanded the platform and the sales force and so the Q1 numbers are really the result of a year's prior work. And so we see good opportunities in the SBA 7(a) business here in the rest of the year, if we continue to pursue it.

It's an area a number of banks have expanded. There is a good level of competition out there, but our customer base is very well suited for the small business products.

We have a significant number of small business customers at the bank and so we're targeting those clients as they look to expand in addition to using it to bring new business into the bank. And then the mortgage business, it is a combination, again. The legacy Heritage branches prior to the merger didn't have an active mortgage platform.

And so we've seen a tremendous number of referrals coming out of the entire retail system, commercial system and other departments at the bank, all across the bank, into the mortgage platform. And then on top of that we also have rates dropping and some strong purchase and construction activity going on within the markets that we operate in.

So it's been a combination of all those factors..

Okay. So the nearly doubled pipeline at 3/31 versus 12/31 in the mortgage portion of the business, that's not purely based on refinance.

That's also based on continued traction as you combine the businesses?.

Yes, of that total pipeline, Jackie, 52% of it is refinance business and then there's 33% purchase and then 15% construction. The 15% construction is all custom construction business or owner-occupied use. There is no spec activity within that department..

And then I just had one other quick one for Don most likely. Were there any -- I know that all the cost savings are now out.

Were there any that were implemented in the quarter? Or is 1Q a pretty good run-rate?.

I think it's a pretty good run-rate overall. There is always going to be some tweaks to it, but again, we had a little bit of merger-related expenses. Again, I think the real estate-owned expenses were elevated, so take that into consideration.

We've, historically, done a really good job of keeping the valuations on those such that we don't have gains or losses. This last quarter, again we had about $400,000 of I think, related to either loss on sale or valuation. So I would say that hope that would not occur in the future. But the other expenses I think are pretty good.

Again, there is going to be some ups and downs, but overall I think it's probably pretty good..

[Operator Instructions]. We do have a question from the line of Tim O'Brien with Sandler O'Neill & Partners. Please go ahead..

Last quarter you guys alluded to maybe some hiring 5 to 10 FTEs possibly in the cards for the start of the year. What did you guys end the quarter with on an FTE basis..

I'll give you a little bit of overview and Don can add some color to it. We continue to hire a few lenders and some of those are replacement lenders and some of them are new lenders. And maybe Bryan can give a little color on that.

And I think that there were some back room positions that we felt we needed to hire for to continue to integrate process, et cetera. And then I think the quarter was affected by just averages. So you may want to speak to that, Don..

FTE, full-time equivalent employees, kind of a calculation in March. It's lower, the 730 we have listed there is -- the average for the quarter I'll say is more of a 764 range for the quarter because it just, again, it has to do with number of kind of working days.

And so I would say our headcount, though, has probably stayed pretty even from the prior quarter overall, from prior-quarter end. We haven't had a lot of -- there is still, obviously some potential back-room hiring's that could occur, but I think the overall FTE levels haven't really changed a whole lot since then..

Bryan, you might want to speak to -- mortgage lenders and other lenders..

We've done some expansion on the mortgage side. We started the year with a budget of around 30 FTE in that group and moved it up to 35. And it will perhaps go a little higher here in the second quarter depending on what happens with the pipeline.

And then on the commercial side, we're about even in terms of production staff in terms of where we were at the end of the year. There has been some retirements and departures and hires, but in terms of the total number of production FTE on the commercial side, it's even with where we ended the year..

And then just to clarify some of the remarks on the call, you said the pipeline for commercial was $291 million. Did I catch that right? That was up pretty substantially from 12/31..

Yes, it's $296.7 million at the end of the quarter, up from $206.5 million at the end of the year. The end of the year number was down from the prior quarter because the fourth quarter of last year was an extremely strong production quarter..

And then you guys also said that given the strong loan growth that you experienced this quarter, that it's possible growth might not hit the 1Q levels here in Q2.

With the strong pipeline and that comment, what's the reconciliation there? Are you expecting maybe some higher payoffs?.

Tim, that's a little difficult to predict. As I said in my comments, we're continuing to see higher-than-historical levels of pre-payment activity. I think it's coming from a lot of different areas, as real estate values improve, sellers are taking money off the table.

There is some refinance activity that we choose not to participate in, especially at the very low 10-year-fixed levels, etcetera. We're also using a stronger economy to manage out some of our poorer quality loans. So there's a variety of things.

It's possible that as we move through the balance of this year that pre-payment activity in any one quarter could be substantially higher than we anticipate which is going to affect the net production or excuse me, the net loan totals.

I do feel comfortable and optimistic that our production totals will continue and I think we feel pretty optimistic that that's going to continue strong for the balance of the year. The wild card is that pre-payment activity that's really hard to predict.

Having said all that, we still are comfortable with that 6% to 8% loan growth guidance we've been giving year-over-year..

And then a question for Don. So your reported comp number for 1Q was $14.225 million.

Was there anything one-time in that related to, I don't know workman's comp expense or payroll tax accruals or anything like that?.

There is nothing significant in that that I'm aware of. There's always for I guess highly [indiscernible] there is always some taxes that gets paid off. FICA is higher at the beginning of the year than it can be later in the year. But I don't think that's a really significant amount to be in there. As far as run-rates go, there is always--.

Don, you're kind of breaking up..

Can you hear me now?.

Yes, maybe..

Okay. As far as run-rates go, there's always increases throughout the year. So obviously, things do go up throughout the year on compensation as salary increases do occur. But overall, I think it's a decent run-rate..

And then, looks like data processing costs have stabilized around $1.6 million.

Does that seem like a decent run-rate number?.

I think it is, with the potential of even lower amounts, Tim. And that gets to the contract renegotiations that I alluded to. I think we could have some successes as we move through the year to lower overall data costs. Hard to give guidance because that's -- we're still in negotiations, but I do think there could be some improvement there..

And then last question. As far as fee income is concerned, the other line item, other fee income, past couple quarters has been about $1.6 million it looks like.

How much stability is there in that number? Or is it going to be volatile here? Does the $1.6 million reflect the blended revenue opportunity of the two banks? That's a decent run-rate going forward?.

As far as $1.6 million, we have over the last few quarters benefited from some recoveries of loans that were -- I think we mentioned this before -- that weren't -- actually had zero balances that we acquired and we've gotten some recoveries. They weren't recoveries of charge-offs; therefore, they didn't go through the provision.

They were actually loans that had no balances, but we were continue to try to recover on through deficiency notes or whatever. We have had some nice income from that. It's hard to predict how much that will be in the future, that could come down some.

But I still think $1.6 million, it might not be $1.6 million going forward, but I don't think it's going to be significantly lower than that..

Was there a recovery of that sort in the first quarter? And how much, if there was?.

It was about $800,000 the first quarter, but we've been getting some of that every quarter..

[Operator Instructions]. Mr. Vance, there are no questions in queue..

Okay, Lois. I appreciate your hosting today. I appreciate everybody that has called in. And we may see some of you at the investment conference that's coming up in Q2 and Q3. So appreciate everyone calling. Thanks very much..

Thank you. Ladies and gentlemen, this conference will be made available for replay after 1 PM today through May 7. You may access the AT&T executive replay system at any time by dialing 1-800-475-6701 and entering the access code 357073. International participants can dial 320-365-3844.

Again, the numbers are 1-800-475-6701 and 320-365-3844 with the access code 357073. That does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect. And speakers, one moment, please..