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

Jeff Rulis - D.A. Davidson Matthew Clark - Piper Jaffray Jacque Bohlen - KBW Tim O’Brien - Sandler O’Neill & Partners Tim Coffee - FIG Partners Louis Feldman - Wells Capital Management.

Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial Second Quarter Earnings Call. At this time, all participants are in a listen-only mode and then later we'll conduct a question-and-answer session instructions will be given at that time. [Operator Instructions]. As a reminder, the conference is being recorded.

I'll now turn the meeting over to your host, CEO, Mr. Brian Vance. Please go ahead, sir..

Thank you, Laurie, I appreciate it. Good morning, everyone or good afternoon, I guess, if you’re on the East Coast. I'd like to welcome all who called in and those who may listen in later in a recorded mode. Attending with me this morning in Don Hinson, our CFO; Jeff Deuel, President and COO; and Bryan McDonald, our Chief Lending Officer.

Our earnings press release went out earlier this morning in a pre-market release and hopefully you've had an opportunity to review the release prior to the call. And please refer to the forward-looking statements in the recent press release, especially as we get into the Q&A session later in the call.

I'll begin by just a few highlights of our second quarter, diluted earnings per common share were $0.39 for Q2 through 2017, compared to $0.30 for Q2 ‘16 and $0.31 for linked quarter Q1 ’17. Return on average assets was 1.21% and return on average equity was 9.54% and return on average tangible common equity was 12.78% for Q2 /17.

Total loans increased $84.6 or 3.2% during Q2 and year-to-date net loans have increased $107.1 million or an annualized rate of 8.3%. Don Hinson will not take a few minutes and cover our financial statement results.

Don?.

Thanks, Brian. I'll start with the balance sheet. We have total assets growth in Q2 of 2.7% or 10.9% on an annualized basis. As Brian mentioned, we have strong loan growth in Q2, which has increased our year-to-date annualized growth rate to 8.3%. Total deposits grew $47.8 million in Q2, which is 5.9% annualized.

In addition, our non-interest bearing deposits grew $38.6 million or 17.6% on annualized basis in Q2. Moving on to credit quality, our credit quality remained stable in Q2, non-performing loans remained relatively unchanged at $11 million or 0.40% of total loans.

The ratio of our allowance for loan losses to non-performing long stands at a very healthy 298%. In addition, included in the carrying value of the loans are – sorry, $11.2 million of purchase accounting that discounts, which may reduce the needs of allowance for loan losses on those related purchase loans.

We had net recoveries of 26,000 in Q2 and year-to-date our net charge-off to average loans is 3 basis points, an improvement of 27 basis points from 30 basis points during the same period in 2016. Our net interest margin for Q2 was 3.92%. This is a 3 basis point increase from 3.89% in Q1.

Pre-accretion and net interest margin remained at 3.75% for Q2 from the same percentage in Q1. New loans for Q1 were originated at weighted average rate of 4.60%, an increase from 4.40% in Q1 and from 4.06% in Q2 2016. This is the highest quarterly average rate of originated loans since Q2 2014.

Deals on interest earning assets increased 5 basis points to 4.14% for Q2. This is partially offset by a 3 basis point increase in cost of funds during Q2. Non-interest income increased $3.3 million from the prior quarter. This increase was due mostly to a $3 million gain on sale of acquired purchase credit impaired loan.

Service charges increased 213,000 or 5.1% from Q1 and increased 950,000 or 27% from Q2 2016. These increases were due mostly to the impacts of the deposit account consolidation process which we have previously discussed..

Total non-interest expense to average assets remained at 2.85% in Q2 from the same percentage in Q1 a decrease from 2.87% percent in Q2 2016. I’ll pass the call to Bryan McDonald, who will now have an update on loan production..

Thanks, Don. I'm going to provide detail on our second quarter lending results by production areas, starting with our commercial lending group. In the second quarter, commercial teams closed $213 million of new loans, which is up from $121 million closed in the first quarter of 2017 and $211 million in the second quarter of 2016.

Commercial team pipelines entered the second quarter at $360 million, which is down slightly from $362.6 million at the end of the first quarter 2017, but up from $273 million at the end of the second quarter of 2016.

Line utilization was 37.8% at the end of the second quarter and has relatively unchanged from 36.4% at the end of the first quarter of 2017. Don mentioned the 4.6% average rate on new loans in the second quarter - new commercial loan rates were also 4.6%, which was an increase from 4.25% in the first quarter 2017.

SBA 7(a) production in the second quarter totalled 10 loans for $6.2 million and the pipeline ended the quarter at $15.5 million. This compares to the first quarter of 2017 when we close the 11 loans for $5.4 million and the pipeline ended at $14.8 million.

Consumer production during the quarter was $53.3 million, which is up from $35.5 million in the first quarter of 2017. Branch retail loan volume comprised $27.2 million of the total, which is up $16.5 million from last quarter and the indirect loan volume was $26.1 million, which is up $1.3 million from the first quarter.

The growth in retail branch volume was due to an increased emphasis on direct consumer lending, primarily home equity lines of credit. As we look to offset a plan with lower growth rate in our indirect loan portfolio.

The mortgage department closed $33.7 million in new loans during the second quarter compared to $33.3 million of new loans during the first quarter and $43.6 million in the second quarter of 2016.

The mortgage pipeline ended the second quarter at $29.7 million, up from $22.6 million at the end of the first quarter of 2017 and down from $38.6 million at the end of the end of the second quarter of 2016. Current pipeline is comprised 43% of refinanced loans, 37% purchased loans and 20% constructional loans.

That compares the last quarter's pipeline where refinanced business averaged 42%. I'll now turn the call back to Brian for an update on capital management, as well as some closing comments..

Thanks, Bryan. I'll start with capital management. Regular dividend payout ratio for Q2 was 33.3% and for the first six months of ‘17 was 35.7% comfortable within our guided 35% to 40% payout ratio.

We continue to believe our capital position sufficiently supports our balance sheet risk, our internal growth and potential future growth for both organic and M&A. Like to just close with a few comments in terms of our outlook for the balance in 2017.

I know I'm sounding like a broken record with these comments, but we continue to be optimistic about the overall economy of the Puget Sound region for the balance of ‘17 and for our continuing growth. And I'd like to cite just a few economic data points for you.

Many of you probably saw this that last week CNBC announced their annual top states for business and Washington state was named America's top state for business in 2017. Additionally, they indicated that Washington State has the country's largest concentration of STEM workers, science, technology, education and math.

And then there's one other statistic from the Bureau of Economic Analysis, Seattle ranks, the Seattle economy ranks 12th largest in the country by GDP which has increased 5.2% since 2014. So there is reason for us to be optimistic. Seattle in the Puget Sound region continues to enjoy some very nice growth and recognition.

We are particularly pleased with our long growth for Q2.

While we are fairly confident loan growth would be stronger in Q2 than Q1, it was gratifying to see the pull-through rates perform consistently with our increased pipeline numbers, given us even more confidence in the validity of our pipeline management process and the ability of our lenders to close the deal.

We all may have noticed a press release last week announcing the addition of a team of season bankers in Portland, Oregon. We are pleased to be able to attract this team of talented bankers and we're encouraged with the recent successes from this team.

Commercial real estate construction continues a robust and will remain disciplined in our monitoring of our commercial real estate loan production concentration risks. As we have mentioned in the past, our robust CRE concentration management processes are likely to continue to impact future long growth.

We remain comfortably under the regulatory CRE concentration guidelines at approximately 250% of capital. We are pleased to note the 3 basis points increase in our NIM quarter over quarter, as well as seen our non-accreted NIM holding steady in Q2.

This is the second quarter in a row that our non-accreted NIM has held steady given us and the degree of confidence we are marking the bottom of future NIM compression. While, our overhead ratio remained flat – excuse me, quarter-to-quarter. Please keep in mind the added expenses of our Portland team referred to earlier that occurred also in Q2.

We continue to expect M&A activity in a smaller less than $1 billion range to increase this year and we hope to be active in that arena. That completes our prepared comments and Laurie we would open the call for any questions that may be out there..

[Operator Instructions] And our first question from Jeff Rulis with D.A. Davidson. Your line is open..

Thanks. Good morning, guys..

Good morning, Jeff..

Morning..

Brian on the - your last comment on the sort of the - I just want to confirm on the expense and the Portland team that was a lot of the comp add linked quarter is it correct?.

I believe it was done..

Yes, that's correct..

Okay. And then I guess the outlook then. Well, one other specific on the expenses, the branch consolidation that you had in April did it that add to any cost in the quarter or did you already expected benefit in the second half, I think….

I think with our branch closure expenses that onetime close them, I think we were pretty even. I think we'll see a little bit of benefit from that in Q3, but again will be offset somewhat by the addition of the Portland team..

As they're on for a full quarter?.

Yeah..

Okay.

So sort of a flattish expense, you had a little bump with the team, but from here there's some offsetting that you think the run rate is modest growth from here, just kind of holding the line?.

I think when you're looking at expenses and the comp expense, I think it's – the run rate is probably pretty good at this point when you’re netting them out..

Great. And then again Brian, you've touched on - kind of you guys have been cautious on CRE and talked about the multifamily segments. I guess is that a little more specific to the growth that you saw I guess above or maybe the long-term or the year guidance that you've given.

How do you see that play out in the back half of the year? You said it could restrict growth in CRE, but this quarter seemed a little above that level?.

Well, I'll invite Brian to add some comments to this as well. But remember keep in mind that the key one is – it was a cyclically slow quarter.

You know, I think that my comments about the pipeline integrity you know, as we - when we combine the company a few years ago that was something that took us a little while to really dial in to where we had some confidence in the pipeline process.

And you'll recall from Q1 that even though the growth was cyclically lower we still had a very strong pipeline going into – from Q1 into Q2 and that certainly did bear out in the Q2 performance and pipeline numbers remain strong.

So I guess my big picture on this is that, you know, I mean, when I say when concentration risks are somewhat of an impact on loan growth because we are turning away some CRE opportunities because of that. But on the other hand, we're seeing growth in other sectors that is nice to see. So Bryan, I'm sure you have comments as well..

Yeah, I would just add on to what Brian said. The growth we saw in Q2 was really balanced. We had good growth on C&I owner occupied, you know, non-owner, a little bit in construction and a little bit of consumer, a lot of the consumer volume that closed was home equity.

So as those lines fund between now and as we go through the rest of the year and if you try I think that will you know, that will give us some additional volume. But the key is just to keep it in balance. There is a lot of commercial real estate opportunities. I won’t say an unlimited amount but many, many, many construction and owner occupied.

So our challenge is keeping in all the categories in balance as we go forward path, pretty pleased with the teams in Q2, real balanced result..

Okay. Thanks..

We’ll go next to Matthew Clark with Piper Jaffray. Please go ahead..

Hey, good morning..

Good morning, Matthew..

Curious on the team you picked up in Portland, you know, how large of portfolio they may have been managing prior to you acquiring them?.

Yes, Matthew. This is Bryan. I mean, we're not going to go into details just for competitive reasons and you know, today we've got 17 members down there and came from you know three different banks. And so over time you know, we've got additional postings out. We hope to have you know, a blended team.

But we're very, as Brian mentioned, in his opening comments we're very pleased with the results so far. We're obviously early at, but good reception of the market and the team has a nice reputation, experience in the market. So we're optimistic..

Okay.

And does this Bryan maybe make it – is it less of a need to find an M&A deal in the Portland market as a result this, have you feel like it would be helpful to kind of build around them?.

Well, just to remind folks that are on the call. We've had a Portland presence since 2007 I believe very small presence. We - from a strategy point of view we decided a couple of years ago to really focus on Seattle, Bellevue and building that presence out. And I think that – and I think we've been fairly successful at that.

And I think that we continue to focus on growing Seattle, Bellevue. But it was time to turn our attention to Portland and as Brian indicated, we believe we've picked up a nice team from actually a couple of organizations that have some consolidation in that market.

In terms of I think future growth, we're looking to continue to add up - for that team to engage and get some real traction in that market, we believe that will happen. As to the - as to whether there's M&A opportunity in that market, we would love to add on from an M&A perspective. But as I keep saying though, banks are sold or not bought.

So folks need to come to that conclusion. And when and if they do we will be very interested to have discussions because we would love to build out a much stronger, I'll say Portland metro market presence..

Okay, great. And then just on gain on sale, obviously a big number this quarter.

I suspect we'd see that normalized going forward? How much think there's some resilience there, more resilience?.

We actually broke it at the table in the earnings release just - about, you know, broke the mortgage from the other. And it was about $3 million. Again, it was considered more of a you know, one-off. We did this once last year. It happened to a similar situation where we found a buyer for a note that we like the price.

And so we had in third quarter of last year I think we're like 2.1 million. This was a – again, its percentage purchase credit impaired loan that was up, you know, hotel had been break down quite a bit and we ended up having to find a buyer that was – with very attractive price. And so we ended up selling a note for $3 million gain..

And I will add that this was an asset that was picked up in an FDIC assisted transaction several years ago..

Great. And then just last one for me. Obviously, credit very good and benign. But just curious if you guys have done a deep dive on the retail series to try to isolate you know, the piece that might be you know, not only the big box stuff, but also the stuff that might be at risk of kind of the Amazon effect….

You know, that’s an area that continues to cause us some concern internally. We talk a lot about it.

And when I talk about CRE concentrations that's one of the specific areas that I'm referring to in terms of very limited growth in that space going forward, because then we've been talking about this for probably the last year in terms of the risks in that space.

And when you think about it, it's just not - even though there is the Amazon effect et cetera you tend to think well it's only going to impact you know the bigger space, but we all know that real estate values are based on comps and if there's difficulties in the larger space it's going to - it's going to filter down to the smaller note size too.

So we're looking at this across the footprint and across all the loan sizes and types as it pertain to retail space. As it pertains to what's in our existing portfolio. We're evaluating that. We don't see any weakness currently and we don't believe we have concentrations in that space.

But at the same time, I know it's got the attention of our credit folks and this is something that we're managing closely. And I think the fact that we've been on this focus for at least the last year. You know, I think there's going to be issues in this space for all banks in the future. But we don't see any concern within the portfolio currently..

Okay. Thank you..

You bet. Thank you for questions Matthew..

We’ll go to Jacque Bohlen with KBW. Your line is open..

Hi, everyone. Good morning..

Good morning, Jacque..

Touching on deposits now Brian, the movement between the money market and the NOW accounts that took place in the quarter was that related to rate movements or was it more of an internal focus?.

Jacque, this is Don. This had to do with our sweep accounts how they were classified. And we kind of - were kind of moving some deposit accounts around and so between NOW and money markets mostly due to this sweep accounts and how they got classified..

Okay. So it was more of a classification issue than anything else..

Correct, correct..

And how have customers been reacting to the rise in rates. I know deposit cost were up a just a little bit in the quarter.

Just any color you have there and kind of conversations you may be having since the June rate increase?.

I think that - I think there's more sensitivity to rates than it have been in the past. We’re getting more calls about that. We actually haven't really increased our rates much if any. Overall, I think we're probably - probably do a little more exception pricing than we've done the past.

But overall we've been able to hold it, but I can see where you know, as we have continue to increase that the customers are noticing and over time that we will need to increase our rates..

Okay.

So the movement in account rates that happened in the quarter that was more proactive customers just reaching out to you?.

Yes, and we have some - you know, we have some accounts that we have kind of have an agreement with that were moving you know, same sense of maybe tied to the funds rate or something like that. But don't want the majority obviously, but there's a there's a few accounts like that into the new accounts..

Okay.

And have you outside of the sweep movements in the quarter have you seen any change in deposit or behaviour in the types of accounts that there might be moving their money around in between?.

No we really haven't. I think you know, we continue to get good non-spring [ph] demand deposit growth. So I think that's positive and that's a nice anchor on the NIM because there's no renewal rates on that. So I don't really notice anything unusual in customer behaviour as far as the type of deposit accounts..

Okay.

And the growth in non-interest bearing that you had in the quarter was that related to new loan relationships or just increasing balances from existing customers?.

I think you know, we get - at the end of the first quarter and in that time frame March, April, we tend to have a lot of various types of payments going out and although I would say that some tax payments were postponed until April, still we tend to start dropping in March, April and build - start building back up.

So I think we were down a little bit, we didn't have much growth. You know, if you look at year end to March, we didn't have much growth at all, that it was down a little bit in the demand deposits. I think it just kind of cyclical, I think as we're starting to build the back up..

Okay. All right. Then just one last one, probably for Jeff. And I know in the past we've talked about some of the new fees that you're able to charge just as you you've re-evaluated some of the products that you offer.

Are we had a good run rate and given the growth that you saw in service charges into 2Q or is there still more room for improvement there?.

I think there's actually more room Jacque, because if you recall we did our consumer deposits rationalization in December and we knew it was going to take several months to fully impact us, which I think is the majority of what you see.

But we've also - we're in the process of doing a similar rationalization of our business line or our business products. So I think there's more to come on that front. We're pretty pleased with the results so far though..

Okay.

And do you have a general timeline of when you might complete the evaluation of the business deposits?.

Probably closer to the end of the year, it would be maybe beginning of the fourth quarter, around that time frame maybe.

It should be fully implemented and all of the communication and responses from customers or changes that they might make is a result of them seeing the way things are working well probably flow through the next three or four months..

Okay. Sounds good. Great. Thank you..

Thanks, Jacque..

And our next question from Tim O’Brien with Sandler O’Neill & Partners. Please go ahead..

Good morning..

Hi, Tim..

I don't know if you guys touched on this.

I didn't capture it if you did, but slower housing listings in the Pacific Northwest is that impacting mortgage production for you guys?.

I'll ask Bryan to maybe comment on that. Also one of the statistics - economic statistics factors in our Seattle paper this morning as home prices increased 12.7% ‘16 – ‘17 over ‘16 in June, the highest increase of any market in the US. So obviously the single family market is you can say it's hot from a valuation point of view.

But that really is driven by two things, one demand, people move into the area and two is a slowdown or a lack of inventory. And so when you see the lack of inventory that is translating a bit in slower mortgage volumes because there's just not enough home.

So kind of the big picture to that's, so that’s where we are and Bryan probably got some more specifics..

Yeah, for sure. There is you know, many customers coming in and getting pre-qualified and then bidding on multiple houses and having trouble you know, actually acquiring a home. So there's a lot of additional time spent and work spent on you know, that phase without a immediate conversion into a home purchase.

So yes, for sure it's holding our mortgage client because inventory is low..

Great color. And then I saw you guys had a nice uptick in swap - interest rate swap fees this quarter is that going to bounce around from here.

I mean, prior quarters you've done better, still how should we look at that number?.

Yeah, it is up over first quarter, second quarter last year. It does bounce around 10. We had a really strong finish and you know, in the fourth quarter last year as well in ’16.

Back to some of Brian's comments on commercial real estate you know, as we are careful in terms of keeping our mix the same that does have an impact on the swap volume because much of it tied to the commercial real estate bucket.

But this is a long way say yes I think it will bounce up and down, but we still have a pipeline on up-swap activity pending..

And then last question. So you know, looking at total non-interest expense, were there, I guess non-recurring initiative related cost around your deposit rationalization initiative or you know where the residual cost with branch consolidation this quarter, that's gone, but probably that that was fully captured in 1Q.

Were there any issue related cost that are non-recurring that you guys showed this quarter?.

Tim, No I think it's - there's nothing really outstanding during the quarter, it's up again. We did again closed some branches that actually happened I think in April.

So there were some costs associated with that, but they were kind of offset by the – because they happened in April, we’re somewhat breakeven for the quarter and then of course the hiring of the Portland team which occurred after April kind of you know, we're kind of offsetting.

So I think this is - the run rate it can fluctuate some, but it's not going to fluctuate on lot [ph] what we have here..

And then what was the date of the start of that team?.

The first five started mid-May..

Thanks a lot, guys..

Thanks, Tim..

And we'll go next to Tim Coffee with FIG Partners. Please go ahead..

Thanks. Good morning, gentlemen..

Morning, Tim..

I got a little late on the call, and quite missed this, that you mentioned already.

But the loan growth that occurred in the back half of the quarter, I think you said about two thirds of that occurred in June? I'm wondering what the incremental pickup was in net interest income from that?.

Well, I think was - helpful again our new loans came in at 460 this quarter compared to 440 and again most of that - I don't know the incremental income pickup from just those loans.

But I can also tell you that our weighted average kind of average rate within the portfolio at the end of the quarter was I think about 9 basis points higher than the weighted average rate from the end of the prior quarter. So if that gives you any hint there.

In addition, that’s the combination of - obviously we had another – we have some resets during the quarter in addition to the new loans coming on at 460. So I think the combination of there were - I'm pretty optimistic about our you know, our pre-accretion loan yields going forward..

Okay, great. That's good. Thank you very much.

And then just kind of - I know the utilization rates in the lines of credit are relatively flat quarter-over-quarter, but are you seeing any change in those dynamics or has your outlook for you know, potential for utilization rates to drop or increase changed in the last couple months or so?.

This is Brian. You know, we haven't seen a significant change there in the last couple of years. We are seeing an increase in commercial loan demand for kind of what I call the C&I side, equipment or expansion you know, continues to increase.

And so I don't know if that will translate into you know a higher utilization rate because a lot of the borrowers, you know, they try to manage for significant line capacity when they're looking at new projects. But overall, we are continuing to see improving commercial loan demand here and in our market..

All right. Those are my questions. Thank you very much..

Thanks, Tim. Appreciate it..

[Operator Instructions] I will go next to Louis Feldman with Wells Capital Management. Please go ahead..

Good morning. I apologize….

Hi, Louis….

If you touched on this, because I had to step away in the middle of the call for a second. Did you – can you - did you give some granularity on what you're seeing in the indirect auto markets.

And you know where you're concern - what concerns are starting to arise for it?.

Lou, this Bryan. Yeah, we're not seeing any deterioration and payment performance or quality. You know, obviously, we're in a very strong employment market here in the northwest and that's our primary driver of credit quality in that business. And we've you know been moderating our growth somewhat in 2017.

We're targeting you know, somewhere around 10% target there in that business just because we've had such strong growth the last two years, not a concern over the credit quality, just more of a keeping portfolio balance. So at this point the job market is strong and had our quality is strong..

Okay.

So you're not seeing credit deterioration within your portfolio at this point?.

No, it's actually very strong. It's improved over the last year and that was very strong year ago, but again it all ties back to employment, primarily because of the grades that we're targeting in the portfolio on the higher end of the spectrum.

So it's typically somebody losing their job or some sort of a similar change that's causing that deterioration..

Okay. Great, thank you very much..

Lou. This is Brian. I’ll just comment kind of five big picture again on indirect.

Those that have followed us for some time will remember that the indirect product came to us as a result of the merger from the Whidbey Island Bank and I have said to many of you previously this was a portfolio that I had a high degree of scepticism over just because that's kind of my background.

And you know through the years that indirect portfolios can be a problem. And I know that this is an issue nationally, that's getting a lot of attention. So I appreciate the nature of your question.

However, because of my concern when we brought companies together, we've done a substantial B size [ph] into that portfolio in terms of underwriting rationale. Just incidentally this is all indirect within our footprint, but either we've done business with for many years. And this is a portfolio that has performed very well.

During the downturn, since the downturn, we continue to follow a variety of metrics. And while I'm not predicting that this portfolio won't experience increase difficulties, I really feel good about the quality of the paper that's - that that goes into this portfolio and you'll also may know from previous conversations, we've ramped back our growth.

I mean, it's still growing, but much smaller. So I think the consumer growth that you're going to see in our balance sheet over the next several quarters is likely to be direct consumer oriented in the form of home equity as opposed to dealer.

It's not that we're getting out of the dealer business, it's just we've got to a point again when I talk about concentration management, it's very critical in all of our portfolios. We've got to a point that we were comfortable with the concentrations, but we didn't want to grow as much beyond where it is.

So if the volume today is really a maintain volume and future consumer totals growth is likely to come from the direct side of the house just to give you a bit more color..

Great. Thank you much..

Appreciate the question. Thank you..

And I'll turn it back to our speakers for closing remarks..

Laurie, thank you for hosting. You've done a great job. Appreciate all that's called in and had interest in our company. We will see many of our investors next week in New York at the KBW conference. So look forward to chatting with you then. That concludes our call today. Thank you..

And ladies and gentlemen, this will conclude our teleconference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect..