Brian Vance - Chief Executive Officer Don Hinson - Chief Financial Officer Jeff Deuel - President and COO Bryan McDonald - Chief Lending Officer.

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

Ladies and gentlemen, thank you for standing by. And welcome to the Heritage Financial Second Quarter Earnings Release. For the conference, all participants lines are in a listen-only mode. However, there will be an opportunity for your questions. Instructions will be given at that time.

[Operator Instructions] As a reminder, today’s call is being recorded. I’ll turn the conference now over to the Chief Executive Officer, Mr. Brian Vance. Please go ahead, sir..

Thank you, John. Appreciate it. I'd like to welcome everyone who has called in and also to those that may listen in later on a recorded mode. Attending with me this morning is Don Hinson, our CFO; Jeff Deuel, President and Chief Operating Officer; 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 it prior to this call. And as we go through presentation and as well in our Q&A period following, I would refer you to our forward-looking statements and keep that in mind, if you would please.

I'll start this morning with the highlights of our second quarter. We had what we believe the solid quarter with respect to earnings with an EPS of $0.29 for Q2 and a return of -- return on average assets over 1% and a return on average tangible common equity of 10.5%.

In addition, we have strong loan growth for the quarter with an increase in non-covered loans of $68.5 million or 3.2% for the quarter and year-to-date non-covered loans have increased to 5.4% or 10.8% on an annualized basis.

Finally, we are excited about the continued development of our metro market strategy with the expanded team of bankers in downtown Seattle. We will refer to that later in our comments. At this point, I would like to turn it over to Don Hinson and he will cover some financial statement results.

Don?.

Thanks, Brian. I will start with the balance sheet. Total assets increased to $21 million in Q2, primarily as a result of $34 million increase in total deposits during the quarter. Total net loan increased $58.5 million during the quarter.

This increase was funded primarily by deposit growth, as well as the $50 million decrease in the investment portfolio. The stronger loan growth has resulted in an increase in the loan and deposit ratio to 78.9% at June 30 from 76.7% at the prior year end.

The decrease in the investment portfolio was partially due to sales of $33.6 of investment securities for net gain of $425,000. Also during Q2, we had additional $25 million portfolio was purchased bringing the total amount portfolio to $60.6 million. Non-maturity deposits continued to show growth as they increased $63.1 million during Q2.

The increase in non-maturity deposits was partially offset by decrease in CD account balances in the amount of $29 million in Q2. As part of our stock purchase plan, in Q2 we repurchased approximately 305,000 shares and an average price of $16.88. We have 1.07 million shares remaining for repurchase under the current plan.

In addition we purchased -- we repurchased additional 11,000 shares in conjunction with divesting of restricted stocks resulting in 316,000 total shares repurchased during the Q2. Moving on to credit quality, we continue to see overall improvement in credit quality metrics for the non-covered loan portfolio.

Total non-accrual non-covered assets decreased $1.5 million or 17.3% during Q2. This decrease was due mostly to sales of non-covered other real estates loans. The ratio of our allowance for loan losses on non-covered loans -- non-covered nonperforming loans stands at a very healthy 326%.

In addition, nonperforming non-covered assets to total non-covered assets improved to 0.21% as of June 30 from 0.26% as of March 31. Our net interest margin for Q2 was 4.19%. This is a 12 basis point decrease from 4.31% in Q1. The decrease is due primarily to a 9 basis point decrease the impact of incremental discount accretion.

The carrying value of non-covered acquired portfolios decreased $58.5 million in Q2 and the carrying value of covered acquired portfolios decreased $9.9 million in Q2 for total decrease acquired portfolio of $68.4 million in Q2. Pre-accretion net interest margin decreased to 3.84% for Q2 from 3.87% in Q1.

This decrease was due primarily to a decrease in pre-accretion loan yields of 4 basis points to 4.88% in Q2 compared to 4.92% in Q1 as new loans are being booked at rates lower than the current portfolio.

Non-interest income decreased $1.5 million from the prior quarter due primarily to the effects of the $1.65 million gain on the sale of the merchant car portfolio which occurred in Q1. The amortization of the FDIC indemnification asset increased to $304,000 for Q2 remaining balance of the asset is $380,000 as of June 30.

Therefore, we don’t expect significant amount of amortization in future quarters. Of the gain on sale of loans $948,000 related to mortgage loan sales and $334,000 related to FDA loan sales. Finally, regarding non-interest expense, non-interest expense remains fairly steady from the prior quarter.

Due to a combination of steady express levels and asset growth, our overhead ratio showed improvement of 3.01% in Q2 from 3.07% in Q1. I’ll hand it off to Jeff, who will now have an update on strategic initiatives..

Thanks Don and good morning. We began 2015 with a specific focus on three strategic initiatives including the integration of the two legacy banks, developing the metro markets and growing non-interest income. We’re pleased to see that our focus on the integration initiatives during the first half of the year is paying off.

We believe we have achieved the cost sales originally identified early in the merger planning process. And we continue to identify efficiencies throughout the company. For example, we’ve developed and are implementing standardized processes across the footprint.

And we have been renegotiating vendor contracts which should contribute to reduce expenses over the next several quarters. You may recall earlier this year. We identified the need to add more FTE selectively to certain back office operations where we may have been little too surgical, only structured the new combined organization last year.

We made those additions in the first and second quarters and now that capacity needs have settled down. During the second half of the year, we’ll be focused on reviewing and refining FTE levels with the goal of bringing the overall number down. Our second initiative was focused on developing metro markets.

It’s also -- which has also turned out well with the opening of our new downtown Seattle locations in early August and hiring of several highly experienced vendors on the Seattle team. We will continue to selectively recruit in our high growth markets.

In addition, we have also strengthened the cash management team with a new experienced manager, who joined us late last year and a reorganized sales team which was now positioned to support planned growth in all of our markets.

Our third initiative was focused on growing on non-interest income with the specific focus on referrals to mortgage, cash management, SBA, the wealth management, essentially taking advantage of the ability to offer these services across the combined footprint.

To support this initiative, we implemented an internal referral tracking system earlier this year. It’s a system that was embedded in our new core system. And it allows us to monitor referral progress responses and completions. It’s great to see that they are well over 200 active referrals in the queue at this time.

Going forward, we will continue to focus on all three initiatives and we will also continue to monitor and manage our expenses as the year progresses. Bryan McDonald will now give an update on loan production..

Thanks Jeff. During the second quarter, the commercial lending teams closed $183.6 million of new loans, which is up from the $131.6 million closed in the first quarter and $120 million closed in the second quarter of 2014. Non-covered loan totals increased in the quarter by $68.5 million as a result of the strong level of origination.

Commercial team pipeline ended the second quarter at $290.7 million or roughly even with the end of the first quarter. We continue to see increasing loan demand from our customer base and new opportunities from our calling efforts. And at the same time, the competitive environment in the market continues to intensify.

Considering all factors, we are pleased with our commercial loan pipeline heading into the third quarter. Line utilization at the end of the quarter was 38.9%. And this percentage has been relatively stable all of 2014 and year-to-date 2015. The average second quarter interest rate for new commercial loans was 4.23%.

SBA 7(a) production in the second quarter included 16 loans for $6.44 million and the pipeline ended the quarter at $13.7 million. This compares to the first quarter while we closed 11 SBA 7(a) loans for $6.29 million and ended the quarter with $12.6 million in the SBA 7(a) pipeline.

Consumer production grew in the second quarter to $40.1 million of new loans closed. The $40.1 million was comprised of $24.5 million in dealer volume and $15.6 million in branch volume. This compares to the first quarter of 2015 with $30.2 million of new consumer loans.

This was comprised of $23.1 million in dealer volume and $7.52 million in branch volume. The mortgage department closed $46.1 million in new loans in the second quarter compared to $34.5 million in the first quarter and $30.4 million in the fourth quarter of 2014.

The mortgage pipeline ended the second quarter at $46 million, up from $40.4 million at the end of the first quarter and $21.2 million at the end of 2014. The increase in the mortgage pipeline is being driven by refinance volume due to low interest rate and increases in home purchase and construction activity.

The current pipeline is comprised of 50% refinance loans, 35% purchase loans and 15% construction loan. This compares to our 2014 average pipeline where purchase business averaged 55% but on a smaller pipeline. Brian Vance will now have an update on capital management as well as some closing comments..

Thanks, Bryan. First of all, just couple of comments on capital management. We’ve continued our 11% dividend, which represents a 37% payout ratio and is comfortably under range of our previously stated range of 35% to 40% payout ratio. As Don stated earlier, we repurchased 316,000 shares during the quarter.

We will continue to analyze stock repurchases on an opportunistic basis, but are unlikely to purchase stock at current trading ranges. Our TCE remains at a healthy 9.9%, and our strong TCE level continues to give us flexibility on a variety of growth opportunities, as well as other capital management strategies.

I will close with some comments on our outlook for the balance of 2015. We continue to be optimistic about the overall economy of the Puget Sound region. Real estate values across all sectors continue to appreciate modestly and most all economic indicators continue to show metrical improvements.

The Wall Street Journal this morning published a list of major U.S. cities change in airline flight additions. Adjusting for vacation destination, such as Florida and Hawaii, Seattle’s flight increases were second in the nation, adding 25% more flights. By comparison another West Coast city similar to Seattle, San Francisco increased their flights 4%.

While I’m not a bellwether economic indicator, this is just one more indication of a strong Seattle economy. As stated earlier, we continue to be pleased with overall loan growth for the past three quarters. On an annualized basis, non-covered loans have grown 10.8% year-to-date.

Prepayment levels continue at higher than normal levels and while we have given guidance that our 2015 loan growth would be 6% to 8%, we are optimistic our net loan growth will be at the upper end our guidance for 2015, assuming prepayment activity does not spike beyond current levels.

Our non-accretive yields for the last four quarters has been in a fairly tight band between 3.83% and 3.87%. However, we continue to believe our non-accretive yields will show slight -- I'm sorry will show slight decreases for the remainder throughout the year.

Following Q1, we indicated our Q2 efficiency ratio would increase largely due to the lack of a one-time gain we experienced in Q1. However, we are pleased that our overhead ratio improved from 3.07% in Q1 to 3.01% in Q2. We believe our overhead ratio absent our Seattle expansion plans will continue to show slight improvement.

We obviously are pleased with the recent successes in expanding our Seattle presence as a result of the recent Commercial Lending Officers hires. We believe our Seattle expansion strategies will positively affect our results later this year and more so for full year 2016.

As Jeff has mentioned, we continue to be pleased with the positive results for our ongoing integration from a merger with Washington Banking Company and we believe we will continue to see synergy improvements at all levels.

That completes our prepared comments for this morning and we would be happy to happy to entertain any questions that you may have. So, John, if you would like to open up lines for questions..

[Operator Instructions] And first from the line of Jeff Rulis with D.A. Davidson. Please go ahead..

Thanks. Good morning..

Good morning, Jeff..

Brian and Jeff's comments on the expense side sort of keeping expenses in check, but also some of the hiring, I guess going forward your expectations for operating expenses from here..

Yeah. Jeff, if we were to isolate the recent Seattle lender expansion both in facility expense as well as hiring additional individuals and the potential of additional hires as we move through the year, we would just done on the current expenses that we have in facilities and officers we’ve hired.

We would anticipate an incremental increased balance of year at about $750,000..

$750,000 on the full year?.

For the balance of the year..

Okay. Balance of the year..

For the last six months of the year..

Got it. Okay. And then strong loan growth, I guess I was surprise within this segment on the C&I bucket, was non-net flat.

Is that of product as paydowns?.

Hey, Jeff. This is Bryan. Yeah, we did have some paydowns during the quarter, but overall looking at the pipeline overall, we do have good activity in the C&I origination. .

Bryan, do you have sequential paydown numbers last quarter and this…?.

I do. It’s in total month C&I. And what I look at is the large payoffs, the once kind of out of the ordinary over a $1 million and those were $23 million just on the commercial side in the quarter..

Any idea what that was last…?.

I can look, but I would guess an educated guess, but something about half that levels in the first quarter..

And then last one for Brian, I guess. Any update on sort of M&A thoughts.

It sounds like a little of attention going to the CL expansion, but any change in the kind of conversations that you’ve had the acquisition of other banks?.

Jeff, I think from our perspective, we’ve indicated today that we hit the pause button as it pertains to M&A activity. For obvious reasons, we really needed to normalize backroom. But we really focused on organic growth during this period of time.

I think we can see the last several quarters we have been getting strong organic growth and that will continue to be a focus going forward. However, as we’ve stated on occasion, we’ve had a number of smaller banks discussions, but for a variety of reasons, they really haven’t worked for us. And so we declined to move forward on those.

But I think the difference might be that today I do believe we have normalized backrooms, while there is still some improvement in efficiencies and a variety of things that we’re focused on. I think should we or where we to be presented with an opportunity, we would be prepared to move ahead with acquisition opportunities.

I am not predicting with this comment that that’s going to happen. I am just saying that prior to previous comments, we’ve been pretty careful with not wanting to move forward until we have backrooms normalize from doubling the size of the company of late last year.

But we would be confidential, we would be presented an opportunity that works with us strategically and financially, we would be prepared to move forward..

Great. Thanks.

What was the number one city for flights added?.

I would really at this moment I have the article right here. It was Dallas at 38% and Seattle at the 25%..

Okay. Thanks..

Thanks, Jeff..

[Operator Instructions] We will go to Tim O'Brien with Sandler O'Neill. Please go ahead..

Good morning..

Good morning, Tim..

Brian, first question back to expenses in the P&L, were there -- any related to Seattle expansion, was there any cost accrued this quarter that you can isolate for us?.

Very negligible. It would have been less than $100,000..

And then as far as that expansion is concerned, do you see deposit gathering being pretty important for the overall success that you would like to see come from this expansion?.

I do. I will ask Bryan to give you a more color on that. I think one of the things as we go up market and looking at middle market lending, it’s predominantly C&I focused relationships, which also has an opportunity for deposit growth. So I think generally, we would look for deposit expansion.

Bryan, any additional comments?.

Yes. I would just add Tim that we’ve staffed the branch with both a new cash management sales officer and then our -- the manager of our cash management area is also going to be located out of our new office in Seattle. So as we put the strategy together, we’ve been very focused on providing cash management and full service banking.

And we will be pursuing the deposit relationships just as heavily as we will be the lending..

Tim, this is Jeff. That was one of the reasons why I made the comment about cash management. We knew that we are going to be adding further mature strategy and we knew that we needed to beef up our cash management infrastructure to keep pace with the people we are bringing and they would be gathering the deposits..

And as far as, you alluded, this Brian, deal size and potential there, what size of deal would you be comfortable with and do you see an opportunity to lean on deals that you might participate out coming through this banking team you’ve added up there?.

Tim, this is Brian. Our house limit is $30 million and during the last fall, we started doing some larger middle market credits and have already been participating out portions of those that exceed our comfort level with the particular credit.

So we’ve already been active in that last year and we continue to be finding opportunities that meet that business. So yes, we are already active in it and we would anticipate we would do more..

And then one last question.

Could you guys provide a little bit of color on your rate sensitivity profile here at quarter end?.

Well, I don’t think it’s changed a whole lot since the prior quarters. Obviously, we are fairly neutral I would classify it as, maybe slightly liability sensitive in the short run, but overall asset sensitive in I would year two. But even those leanings are very slight, especially on year one on that liability system side.

I think again it’s with our flexibility on the deposit side and on deposit ratio, I think that we would be able to hold our NIM, our finance and the rates of environment..

Thanks for answering my questions..

Thanks, Tim..

And next from the line of Jackie Chimera with KBW. Please go ahead..

Hi. Good morning, everyone..

Good morning, Jackie..

Brian, you had mentioned that with the stock trading words, you are unlikely to do a repurchases.

Does that change how you think about special dividends?.

Well, I think we have given guidance in the last several quarters that as we look to managing our capital, it’s really three points. And that’s special -- excuse me, regular dividends at roughly 35% to 40% payout, this quarter is a 37 %. So we’re within that range. We’ve talked about special dividends. We’ve talked about stock repurchases as well.

Special dividends, we’ve never signaled that this is something that we would continue that -- it's just something that has the word which suggest, it’s special. And so it’s periodic.

It’s probably -- it's something that we will devaluate on a variety of fronts, one is capital levels and our overall TCE at 9.9% was pretty steady of the 10% prior quarter. Now, on the prior -- the first two quarters of this year, we are fairly active on the stock repurchase.

Should there not be stock repurchases going forward in the last half of the year because of values that maybe -- if they were to remain roughly on the same range that they are, certainly, special dividends would be on the table.

But that's something that I think that we would evaluate on a case-by-case basis, both looking at organic growth that would affect capital and as well as looking at potential M&A that would obviously affect capital. So it’s highly depended on a variety of factors. But I would say that special dividends are certainly on the table for consideration..

Okay. Thanks, Brian. That’s very helpful. And then just kind of two-fold question. Looking to the new hires that you added in the quarter, you've had the two senior lenders and then also somebody who has got to run a new Capital Markets Group for you.

How long do you think it'll take for those individual pieces to come up and running before the new lenders understanding it takes time obviously, can actually start to create some loan growth that will see at the bottom line and then how long until the Capital Markets Group creates some fee income for you?.

Jackie, this is Bryan McDonald. On the capital market side, we had already developed a swap program, which is one of the areas that we put under the Capital Markets Group and we’re already set up and now actively managing. And so it's just a question of the deal flow at this point in time. But we already had a set up ahead of time and that was running.

And then on some of the multi-bank business, that's also something that we already had up running and was active. So, really the individual we hired is hitting the ground running and already ramped up on both those fronts.

With the other staff, it's the normal, I would say, the normal sale cycle and difficult to predict although we’re optimistic that we'll have some very good opportunities looking out over the next six months..

Okay. And then looking at the swaps and all the other programs that you have in place and that are already there for you.

Do you have existing customers where you may not have had these in place when you originally book their loans but you can reach out to you and perhaps increase their business?.

Yes, for sure. And it’s also complementary to some of the middle-market business that we’re pursuing. We’re just obviously, wanting to have a toolset that matches up very well with the type of clients that we’re pursuing in the metro market.

And we feel like we really have that both from a product service capability and the staff capability and that's just been enhanced with the recent hires..

Okay.

So perhaps more of a -- to hop out with sales than to drive fee income then?.

For sure. We just got to the point where we really needed a dedicated person to do it. So, we were doing all of the same activities prior to the higher but without a dedicated person and growing to a level where really we needed a dedicated person to manage these elements for us and continue to grow it..

Okay. Great. Thanks for all the color. I appreciate it..

Thanks, Jackie..

[Operator Instructions] And allow me a few moments. No further questions coming in..

Excuse me. John, appreciate it. And if there are no further questions, I appreciate everybody calling in this morning. I'll remind folks that are on the call that the four of us will be in New York City next week, early next week for the Annual KBW Conference.

I'm sure we’ll be seeing many of you there on our one-on-one discussions and look forward to meeting with you and chatting with you and sharing more about what the strategies our company. So, I appreciate everyone’s calling today. Thank you very much..

Ladies and gentlemen, that does conclude your conference. Thank you for your participation. You may now disconnect..