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

Jeff Rulis - DA Davidson & Co. Matthew Clark - Piper Jaffray Jackie Chimera - KBW Tim O'Brien - Sandler O'Neill.

Ladies and gentlemen, thank you for standing by and welcome to the Heritage Financial Third Quarter Earnings Release. For the conference, all participant lines are in a listen-only mode. 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 your host Mr. Brian Vance, Chief Executive Officer. Please go ahead, sir..

Thank you, John. I'd like to welcome all who called in and those who maybe listening in later in a recorded mode. Attending with here in Olympia this morning is Don Hinson, our Chief Financial Officer; Jeff Deuel, President and Chief Operating Officer; and Bryan McDonald, 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 the call. And as always I will refer you to the forward-looking statements as we go through our prepared comments as well as the Q&A after our prepared comments this morning.

I'll first start off with the highlights of our third quarter, and we had a solid quarter with respect to earnings with an EPS of $0.32 for Q3 and a return on average assets of 1.06% and a return on average tangible common equity of 11.2%. We had another strong quarter of loan growth with an increase of $56 million or 2.4% for the quarter.

Year-to-date loans have increased to 6.8% or 9.1% on an annualized basis. In addition we had a strong deposit growth in the third quarter with an increase of $108 million or 3.7%. Shared loss agreements with the FDIC were terminated during the quarter result in a pretax gain of $1.7 million.

That covers our highlight, and now I’ll turn it over to Don to cover some financial statement results for you.

Don?.

Thanks Brian. I’ll start with the balance sheet. Total assets increased to $115 million in Q3, primarily as a result of the $108 million increase in the total deposits during the quarter. The strong deposit growth resulted in a decrease in the loan deposit ratio of 78.0% from the prior quarter of 78.9%.

However, the overall trend is a increasing loan deposit ratio as evidenced by an increase in the ratio from 76.7% at the end of 2014 to the current ratio of 78%. Significant deposit increase in the third quarter resulted in overall cash balances increasing to be $2.5 million at September 30 from $22.8 million at June 30.

Based on the historical performance we do not expect fourth quarter deposits to grow, to be as robust as it was in the third quarter and therefore we expect our net deposits to decrease during the fourth quarter.

During the quarter, the percentage of the demand deposits to total deposits increased to 25% from 24.7% in the prior quarter end and total non-maturity deposits to total deposits increased to 85.7% from 84.3% at the prior quarter end.

Moving onto credit quality metrics, we continue to see overall improvement in credit quality metrics to the loan portfolio. Total non-performing assets decreased $1.5 million or 11.5% during Q3. This decrease was due mostly to sales of real estate loans.

The ratio of our allowance for loan losses on loans to non-performing loans stands at the very healthy 293%. In addition, non-performing non-covered assets to total non-covered assets improved to 32 basis points as of September 30 from 300 basis points as of June 30.

In addition included in the carrying value of the loans are $21.6 million of net discounts which may reduce the need for our loan losses on those related loans. Our net interest margin for Q3 was 4.00%, this is a 19 basis point decrease from 4.19% in Q2.

The decrease was due partly to 11 basis point decrease and the impact of incremental discount accretion during the quarter. Pre-accretion net interest margin decreased to 3.76% for Q3 from 3.84% in 2Q.

This decrease was due primarily to a decrease in pre-accretion loans yields of 13% basis points to 4.75% in Q3 as compared to 4.88% in Q2 as new loans are being booked at rates lower than the current portfolio.

In addition the quarter-over-quarter change in the average earning asset mix investments over net deposit affected the net interest margin negatively.

Non-interest income increased $2.7 million in the prior quarter due mostly to the effects of the $1.7 million gain on the termination of the FDIC shared loss agreement as well as the related elimination of the amortization of the FDIC indemnification assets which was $304,000 in Q2. In addition gain on sale of loans increased to $129,000 in Q2.

Of the gain on sale of loans in Q3, $857,000 related to the mortgage loan sales and the $554,000 related to SBA loan sales. And finally on non-interest expense. Non-interest expense for Q3 increased $1.2 million in the prior quarter. The increase was due mostly to increase in compensation expenses and data processing expense.

The increase in compensation expense was due mostly to personnel additions through the [indiscernible] office as well as expenses related to performance based incentive compensation. But then the processing expense increased in the prior quarter primarily due to incurred fee of [$429,000] in early termination of a data processing contract.

Jeff will now have update on strategic initiatives..

In the later part of 2014, the management team met to determine our strategic initiatives for 2015. And at that time we settled on three strategic initiatives, including; completing the integration of the two legacy banks; continuing to develop our metro market presence in King, Snohomish and Pierce Counties and growing non-interest income.

We remain focused on these initiatives throughout 2015. At this point in the year, we can see tangible results from our efforts. Early in the year, we achieve the originally planned for merger related cost saves, you will recall that it was 10% for each bank or 20% together.

We also continue to identify additional efficiencies throughout the Company including the renegotiation of a variety of vender contracts, which will provide us with significant savings over the coming months. The benefits from this effort just started kicking in during the August-September time frame.

We’ve also centralized all incoming calls to customer service center, which provides us with the opportunity for refining branch staffing going forward. We do remain focused on staffing levels in all areas of the bank and continue to home our FTE metrics. Our second initiatives for this year focused on developing our metro markets.

This initiative has also turned out well with the opening of our new downtown Seattle location in early August and the hiring of several highly experienced lenders upon the Seattle team. At this time our Seattle office is fully functioning with representation from commercial lending, community development, capital markets and cash management.

We are also continuing our selective hiring in Snohomish and Pierce County to strengthen our lending teams in those locations.

Our third initiative had a focused on growing non-interest income with the specific focus on referrals to mortgage cash management, FDA and wealth management essentially taking advantage of our ability offer these services across the combine footprint.

To support this initiative we implemented an internal referral tracking system earlier in the year which allowed us to monitor referral progress responses and completion. The referral process has generated 945 referrals today with 381 of those referrals active and 111 of them closed out or turning into business -- into new business.

We are seeing very good progress in this area. Like I said earlier we’re very pleased with the results of our 2015 strategic initiatives and we are now in the process of gearing to identify our initiatives for the coming years. I’d like to pass it now to Bryan McDonald who will give us an update on loan production..

Thanks Jeff. During the third quarter the commercial lending teams closed 210 million of new loans which is up from a 183.6 million closed in the second quarter and 131.6 million closed in the first quarter.

Gross loan total increased during the quarter by 56.7 million as a result of the strong level of origination and 201 million over the past 12 month. The majority of the quarter grow for the commercial and industrial loan amount which were up 49.5 million.

Commercial team pipelines ended the third quarter at 305.6 million, up from 290.7 million at the end of the second quarter. Loan demand has remain consistent from our customer base and our calling efforts continue to provide the bank a number of new opportunities.

This has been through across the footprint and in the Seattle market for who we have added five bankers to our production fee during 2015. Line utilization at the end of the quarter was 38.5% versus 38.96% last quarter. This percentage has been very stable over the last couple of years. Average Q3 interest rate for our new commercial loans was 3.75%.

SBA 7(a) production in the third quarter included 11 loans for 14.41 million and the pipeline ended the quarter at 5.8 million. This compares to the second quarter when we closed 16 loans for 6.44 million and the pipeline ended at 13.7 million.

The Seattle and [indiscernible] SBA office recently published third-party lender rankings for their fiscal year ended September 30, 2015. On SBA 7(a) lending Heritage Bank ranked number 10 overall and second highest versus other community banks. On SBA 504 lending Heritage Bank number one overall by a light margin.

Consumer production ranked 4.5 million from the third quarter to 35.6 million of new loans closed. The 35.6 million was comprised of 22 million in dealer volume and 13.6 million in branch volume. This compares to the second quarter with 40.1 million of new consumer loans.

The decline in the dealer volume was primarily due to a credit union expanding us geographic presence in August and banking volume. This expansion only impacted August with volumes increasing a prior run rate during September.

The mortgage department closed 46 million in new loans during the third quarter compared to 46.1 million in new loans in the second quarter. The mortgage pipeline ended the third quarter at 35.6 million, down 46 million at the end of the second quarter.

The current pipeline has comprised the 56% refinance loans 27% purchase loans and 175 custom construction loan. This compares to last quarter pipeline for a refinanced business averaged about 50%. Brian Vance will now have an update on capital management, as well as some closing comments.

Brian?.

Yes, thanks Bryan, I will start with capital management. We have continued our $0.11 quarterly dividend which represents a 34% payout ratio and is slightly under the range of our previously stated guidance of 35% to 40% payout ratio.

We also announced a special dividend of $0.10, the special dividend of a continuation of at least one special dividend for the past five years including this year. Our special dividend strategies are closely linked to future balanced sheet growth, tangible common equity levels and M&A activity.

Our TCE or tangible common equity remains at healthy 9.8% and our strong TCG level continues to give us flexibility for a variety of growth opportunities as well as other capital management strategies. Comments on just in terms of 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 and most all economic indicators continue to show measurable improvement.

While commercial real estate construction growth is robust in the region, construction activity seems to match demand at this point but we are being careful to constantly monitor and limit loan concentration in high activity sectors.

As stated earlier we continue to be pleased with overall loan growth for the past four quarters with annualized loan growth for each of the past four quarters in a high single-digit or low double-digit range.

These growth rates are net of continuing high levels of prepayment activities that continue to persist as well as the management of FDIC asset workouts. The prepayment activities of originated loans are primarily the result of the sale of real estate or the sale of whole businesses both resulting in early payoffs.

While our loan growth is coming from all markets we do business in, our Seattle strategy continues to overweigh our overall growth. You may have seen our press release of October 16 highlighting three additional lenders to our Seattle location along with the addition of one loan support position.

These three additional lenders are continuation of building out our Seattle team. They all have considerable embedded and deep knowledge of the entire team county markets and each has the potential of building nice C&I portfolios. Each of these lenders are well known to us and work directly with current members of our Seattle team.

We continue to be optimistic our net loan growth will be on the upper end of our 6% to 8% guidance for the balance of 2015. Our non-accreted yield for the previous four quarters has been in a fairly tight band between 3.83% and 3.87% however it's up to 3.76% for this quarter.

As Don stated earlier this decrease was due primarily to yields of new loans but also partially due to increased liquidity. Our non-accreted margin is likely to continue to deteriorate slightly in the foreseeable future due to the continuing low rate environment.

I also believe it's important to note that our strong C&I growth for the quarter is primarily based in variable rate loans which have lower yields but the value of the variable rate going forward is strictly noted.

While efficiency ratio improved this quarter, our [over debt] ratio went up slightly primarily caused by our Seattle initiative and the early contract termination fee reported by Don earlier. We believe we will continue to improve both metrics over the next several quarters.

We obviously are pleased with our recent successes in expanding our Seattle presence as a result of the recent commercial lending hires. We believe our Seattle expansion strategies positively affect our rebuilt later this year and more or so for the full year 2016.

I would look any questions you may have and once again refer to the forward-looking statements in our press release as I answer any of the questions dealing with forward-looking comments. And that completes our prepared remarks, John and we will open the lines for any questions there may be..

Certainly [Operator Instructions]. And first in the line is Jeff Rulis with DA Davidson. Please go ahead..

Thanks. Hi guys..

Hi Jeff..

Really just a couple of questions on the Seattle hires. Wanted to try to get a sense for the impacts to loan growth that those individuals may have kind of a timing thing.

Did you see any bumps already in Q3 or would you expect one in Q4, or is it one of this steady contribution overtime?.

Jeff, this is Bryan McDonald. We did the new bankers have closed loans during Q3 we have had a very good pipeline and production out of Seattle going back the last 12 months. And so with this added group, we just see that continuing. So we did have an impact from the team in Q3.

We’ve got a good pipeline overall and a good share of that coming out of our incoming markets..

Bryan while I have you, just a question on overall paydown activity.

How was that sequentially from Q2 to Q3?.

What we keep close track of is kind of the larger payoffs over $1 million and those were just over $36 million during Q3 versus something closer to $24 million for Q2, so they were up. And Q2 was higher than what our typical run rate would be.

In Q2 we had a number of SBA five or four debentures funds that kind of little bit higher than what we would typically expect. But it was higher and if you looked at the loan composition in terms of the owner and non-owner occupied real estate quarter-over-quarter, that was the primary reason for the decline in those sectors..

Maybe going back to the Seattle hires, Don you’ve mentioned that the non-interest expense is the similar question, any sort of lumpiness in their hires obviously picked up in Q3.

Is there anything extending into Q4 that we should be aware of or maybe fall of from that level?.

Well, I think that what we’ve mentioned before that we’re expecting additional expenses some of the hires again moving to the just still into August and so I think the full -- we’re actually going to have increased expense associated with that initiative in Q4 compared to Q3..

Jeff to that, this is Brian Vance, to that point, I think in Q2’s earnings conference call we had given some guidance that the balance of the year in another words the last six months of the year impacted on that initiative that could be around $750,000, and it could increase maybe to as much as $1 million if there were additional hires and still feel that guidance is appropriate..

Our next question is from Matthew Clark with Piper Jaffray. Please go ahead..

On the core margin, excluding the accretion, with your expectation for deposits to come down, you obviously had excess cash coming down.

I assume is it enough to allow that core margin to maybe bounce back a little bit, even with the ongoing pressure on loan yields?.

Matthew, its Bryan, let me give you a big picture and I’ll let Don fill in some more color. As I mentioned in my comments earlier, I think it’s been important to note that a good bit of our growth in Q3 came from C&I volume. That’s important to note for a couple of reasons.

We have already felt that the Seattle strategy was and will be focused on C&I loan growth. We’re beginning to see that for now in our numbers, and I think that’s good. Secondly, as is those the C&I loans are variable rates and variable rates, they carry lower yields.

And I think that certainly has been passed our loan yields, both from these but the yield of the new loans are being booked as well as the NIM. There are certainly other nuances in the net interest margin, and Don you might want to comment to that as well..

Yes, just to what Bryan said again to add color, originated loans this quarter was down quite a bit, the new loans, with the rates we put on in. But again there’s lot of [indiscernible] to C&I, C&I was little back down so on the average C&I loan I think we’re talking 365 comparing to overall 304 for the quarter.

And then in prior quarters we haven’t had cash as much as from product on their looks like in the low fours in previous quarters the new origination at the big part of it, part of it will be as we leverage more of the cash that that will bring -- that will help the margin some, it will have a significant impact, but it will help us bring it back opportunity..

And I guess on the non-C&I staff in terms of pricing just incrementally compared to last quarter, I think the in terms of new business are you seeing step down at all of those rates basically what market rates have done or you can hear in the fourth quarter or is a non- C&I stuff that remained around where it’s been?.

I would say it has map. It continues to be a pretty competitive marketplace particularly for the quality, the quality loans. But yes, I think the majority of impact to this quarter was more in the mix, the higher mix of C&I and a significant decrease in the lending rates.

Overall rates have continued to come down since last quarter, so that has an impact in the overall reprising of the portfolio which is type to the settle home loan bank index. So as the overall market rates decline why reprising come down. So that’s a pretty big favor of the overall yield in the portfolio..

And just last one just thinking about the opportunity to pick off more season lenders with all the dislocation that’s going on in or around year relative to M&A opportunities. Can you just help us take through those to….

Since we put announcement out last week on the commercial banker editions there in Seattle, we have hired one additional person analyst in that team and that fills out kind of our first phase of hiring in Seattle, we are targeting some additional ads for some specific areas and we continue to be out actively recruiting with that and we continue to be recruiting and all of our markets and we have had good reception continue to have very good reception interest from a bankers -- other banks in terms of talking to the Heritage.

So that’s been an active strategy really something we do all the time. But I can tell you that really over the last period is really bad, very favorable, we’ve had a lot of people interest and talking to us as they go by fortunate of how the focus that we’ve been able to bring aboard and that we continue to have a good reputation in the market..

Matthew this is Brian, I would add to Bryan’s comment in that, we’ve had a very I’ll say comprehensive targeted approach for lender recruiting and in King County for the last year or so and that’s resulted in a new hires that we’ve announced.

I think the other thing that is done as we’ve brought what I would, what I strongly believe are very high quality lenders to the organization is that raise the awareness of Heritage Bank in that market in which we were hoping to unwind to do as well.

Which is also creating a nice side benefit of some inbound calls from this down point of folks that are can be noticed and seen what we’re doing, it's fun to see. I think it's important to say that we’re very so lucky in terms of fit.

We’re looking for a fit on the culture side; we’re looking for fit on a credit quality and we believe we’re getting there. We believe that the strategy has been executed to our desire and I think that as we go forward into ’16 there will be some additional opportunities..

Our next question is from Jackie Chimera with KBW. Please go ahead..

Hi, good afternoon, guys. There was an, and this excludes the 1.7 million in the loss share benefit that you got in the quarter.

But what cause that pop-up in other income this quarter?.

Well I’ll begin, we have some of the -- some low gains which was part of that, we also had some I would say miscellaneous loan income on some loans we were able to get the resolution on that were loans we mentioned before that were never really on our -- never had balance on our books because they were through an [FJ CBO] that came across zero that's where those charge off relate, so therefore came as other income.

So that was part of the other income increase for the quarter..

Okay.

So some of that will be nice bump in the quarter but non-recurring in the future?.

Right, it's [indiscernible] that we've seen, we experienced, I don’t think we did a lot in Q2 but we've had seen that quite a bit over the last few quarters those recoveries come across..

Do you left of those on?.

Sorry?.

Do you have many left of those, any of the potential recoveries?.

There is kind of predict because again we constantly work those set as to see if we can get in and sometimes come through and sometimes they don’t. So again it's kind of hard to predict that I would say as we get further away from the events of the acquisition that you have probably few and fewer apart..

And Jack it is Brian I would just add some color on that and just reminding everybody that there are -- there were four failed institutions now in this balance sheet from Legacy Heritage 2 from legacy [indiscernible] now the lost share agreements have been canceled some of these recoveries going forward are a 100% gain to the bank, some of those that gain will be allow some of the gain as Don just indicated will be through non-interest income depending on how the asset was previously carried.

But I think because there are four troubles, actually four failed institutions and then the balance sheet it's very difficult to predict but I think that there could be and will likely be some of that continuing activity as we move through the next year or two..

And then I wanted, I have a question for Bryan McDonald if you could just update us on where the floors are at and how that number shift as you continue to book more and more C&I growth and how much you think rates would have to rise before you start to see an impact on that?.

Jackie I am going to ask Don to answer that one for you..

Okay..

I think, I don’t think it's really changed come back to where it had, I think again it's we got floors in various periods, I think that it might be [indiscernible] begin to look at the overall interim position of the Company. I think we are pretty neutral overall.

I think that even with our assumptions are being pretty conservative that we or may be slightly liability since so I think we have continued with the C&I loans and liquidity I think we're probably after sensitive and we feel confident it's raised to go up that we are going to be adding to our bottom line going forward. I will answer it that way..

Okay.

And did you have just a round range and if you are willing to describe in terms how raising to go up before you will trigger some of those for us?.

Well I don’t at this point..

Jackie it's Brian, I think probably as who knows what rates are going to do going forward I think that as Don indicated we are pretty even today I think rather than the importance of getting through floor is just a when rates do increase I believe that we are going to see benefit from that in an overall sense.

I don’t think that the floor issue is quite of an issue as it was once before but I think that we -- I don’t know that we have positioned the balance sheet necessarily but it add a fairly balanced portfolio today in this interest rate environment is really not a bad thing to have but on the other hand we would look forward to interest rate increases going forward..

Okay, great. Thanks for the color guys. I will step back now..

Thanks Jackie..

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

Hey Don a quick question for you did you say that there is 26 -- 21.6 million in discount remaining on acquired loans?.

Yes Tim I think that's what I said [indiscernible] quick idea of that..

And what was that number at the end of second quarter just short line me?.

I believe it was see it was 23.4..

And is that credit a combination of credit and interest rate discount?.

It is but there is not a whole lot of interest rate piece to that..

So majority predominantly credit?.

Correct..

And then another question, are you guys in -- if you’ve met the performance thresholds on your sole merchant card book that are going to allow you to capture that half million in incentive in 4Q?.

I believe we’re on track to do that, yes Tim..

Okay, great..

And you have a good memory..

That’s what writing notes is for, Brian, at my age. And then another question did the -- can you give a little color on the deposit, the deposit growth was phenomenal this quarter. And Don you alluded to some guidance saying that there might be -- balances could come down a little bit you could see some deposits move out in the fourth quarter.

Did I capture that -- did catch that right? And can you give a little bit of color on kind of what happened this quarter?.

I think if I look historically at our kind of deposit growth and third quarter is always our strongest deposit growth quarter….

So, seasonal?.

It’s seasonal, there is no real advance like in the first and second quarters, you have some tax stuff going on. And in the fourth quarter you have tax events for the property tax to do some final individual taxes happening and plus some of the holiday type of stuff happening.

So, the third quarter is our quarter where there is really no events in the deposits balances that tend to accumulate over time. And so historically it’s been our -- always been our strongest quarter..

And I would remind you Tim that really the last half of last year and the first quarter -- couple of quarters this year, we were still running off old CD balances of again acquired, failed acquired institutions that have five year CDs out there. So that impacted the net deposit growth for the first half at the earliest..

And then one other question tied to that, the Seattle banking team and the Seattle strategy.

Can you talk a little bit about how you anticipate deposit gathering being a part of that, the goals of that unit and the effort up there?.

We have our cash management lead in our Seattle office and also our cash management sales officer and then here beginning part of next year we have the retail staff that’s going to join the new location downtown.

But we have some very specific strategies set out around deposit gathering and deposit growth from an office based setting versus the traditional branch setting. And so we do have specific deposit strategies to go along with the overall Seattle and King County really plan because it certain impacts our Belvieu office..

Will you find the C&I loans up there without capturing deposit accounts or some sort?.

It’s our objective to bring in full relationships and that has been what we have been successful in doing the last year and the new relationships that some of the new folks have brought upward, we’ve been getting for relationships.

So, it’s both, the strategy is both to do but also to go after some of the larger deposit relationships that exist in the downtown core. We think we’ve got an opportunity to pick up some business there. It isn’t kind of centered around the lending relationship necessarily..

Because some of the deposit growth this quarter was tied to Seattle, those guys brought it in?.

Yes, it was but I wouldn’t say that it was new relationships through Seattle that drove the bump. But along with the lending activity, they’ve picked up deposit relationships right along with that..

Thanks for answering my questions..

Tim, Brian Vance here. I just had a little additional comments to that, and I’ve been pleased that as we’ve looked at the C&I credits at the King County, that gives us, they do bring with them some very nice deposit relationships.

And our relationship mangers they’ve done a great job in really acquiring the total relationship and I anticipate that to continue. Bryan also referred to the addition of the retail team to our downtown Seattle location.

To clarify that point, that is our current West Seattle branch location that will be closed following the first part of the year couple of staff members there will transfer downtown Seattle, just to clarify that point.

And that’s why you will see in our release that were by branch accounts went from 66 to 67 fall back to 66 after the first of the year..

Thanks Brian. Thanks for the color, I’ll talk to you guys later..

And Mr. Vance we have no further questions in queue..

Once again I appreciate everybody’s interest that has joined our call today. Appreciate your continued interest in the company and we will chat with you after Q4 results. Thanks everybody..

Ladies and gentlemen, this conference is available for replay that starts today at 1:00 PM Pacific Time until November 5th at Midnight. You may access the replay at anytime by dialing 800-475-6701 and the access code is 370446. That number again 1-800-475-6701 and the access code is 370446. That does conclude your conference for today.

We thank you for participation. You may now disconnect..