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

Jeff Rulis - D.A. Davidson Matthew Clark - Piper Jaffray Jacque Bohlen - KBW Tim Coffee - FIG Partners Tim O'Brien - Sandler O'Neill & Partners.

Ladies and gentlemen, thank you for standing by and welcome to the Heritage Financial Third Quarter Earnings Call. At this time all lines are in a listen-only mode. Later there will be an opportunity for your questions and instructions will be given at that time. [Operator Instructions] And as a reminder, this conference is being recorded.

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

Thank you, Cathy. I'd like to welcome all who called in this morning, and also those that may listen later in a recorded mode. Attending with me in Olympia this morning is Don Hinson, our CFO; Jeff Deuel, our President and COO; and Bryan McDonald, our Chief Lending Officer.

Our earnings press release went out this morning in a pre-market release and hopefully you've had an opportunity to review the release prior to this call.

And then as we go through the call and especially in the Q&A session, later I would ask you that you refer to the forward-looking statements that is in the -- that is contained in the press release that was sent out earlier today.

I'd like to start with some highlights of our third quarter, diluted earnings per common share were $0.35 for Q3, compared to $0.37 for Q3 2016 and $0.39 for the linked quarter of Q2 2017. Return on average assets was 1.05% and return on average equity was 8.34% and return on average tangible common equity was 11.10% for Q3.

Total loans net increase was $49.4 million or 1.8% during the quarter, year-to-date net loans have increased to $156 million or 6%. Yesterday, the Board of Directors declared a regular cash dividend of $0.13 and a special cash dividend of $0.10 to be paid in November.

I'll turn the call over to Don Hinson; he will take a few minutes to cover our financial statement results.

Don?.

Thanks, Brian. I'll start with the balance sheet. We had total asset growth in Q3 of $59 million and broke the $4 billion asset mark during the quarter. As Brian mentioned, we have solid loan growth in Q3, and as a result, our year-to-date annualized growth rate is 8% to Q3.

Total deposits grew $29.6 million in Q3, and have increased $91 million year-to-date. The credit quality remained stable in Q3. Non-performing loans remained relatively unchanged at $11 million. The percentage of non-performing loans to total loans decreased to 0.39% at September 30, from 0.40% at the end of Q2.

The ratio of our allowance for loan losses to non-performing loans stands at a very healthy 287%. In addition, included in the carrying value of the loans are $11.7 million of purchase accounting net discounts, which may reduce the needs of allowance for loan losses on those related purchase loans. We had net charge-offs of $2.2 million in Q3.

This is mainly due to two larger charge-offs. First, we recognized a $1.5 million charge-off related to the closure of a purchased credit impaired loan pool. This charge-off was related to losses that have built up in the pool over the last 7 years, but were not recognized in charge-off until the pool was closed.

In addition, we've recognized a charge-off of $556,000 related to a write-down of a collateral-dependent land development loan. Our net interest margin for Q3 was 3.85%; this is a 7 basis point decrease from 3.92% in Q2. Pre-accretion net interest margin decreased slightly to 3.74% for Q3 from 3.75% in Q2.

Pre-accretion loan yields increased 4 basis points to 4.57% in Q3 from 4.53% in Q2. This was mostly the result of the increase in prime rate in June as well as the impact of higher origination loan rates in Q2 of this year. New loans for Q3 originated at a weighted average rate of 4.45% a decrease from 4.60% in Q2.

The decrease in rates on originated loans is a result of lower market fixed term rates from earlier in the year. The cost of funds increased to 0.36% in Q3 from 0.31% in Q2, this increase was due primarily to increases in the cost of CDs and overhead borrowings. Our cost of total deposits for Q3 was 0.20% compared to 0.18% in Q2.

Non-interest income was $8.4 million in Q3, a decrease from $10.7 million in Q2. As a reminder, in Q2, we recognized a $3 million gain on sale of a previously classified purchase credit impaired loan. Service charges increased $343,000 or 7.7% from Q2, and have increased $2.9 million or 28% from Q3 2016.

These increases were due mostly to the impacts of deposit account consolidation process that we'd previously discussed. Non-interest expense for Q3 was $28.0 million, an increase of $146,000 from Q2. The increase was due partly to the costs related to the proposed Puget Sound Bancorp merger. These costs were $383,000 for Q3.

Total non-interest expense to average assets improved to 2.76% in Q3 from 2.85% in Q2. Bryan McDonald, will now have an update on loan production..

Thanks, Don. I'm going to provide detail on our third quarter lending results by production areas, starting with our commercial lending group. In the third quarter, commercial teams closed $216.6 million of new loans, which is up from $213 million closed in the second quarter of 2017 and $158.8 million closed in the third quarter of 2016.

Line utilization was 36.11% at the end of the third quarter and is relatively unchanged from 37.8% at the end of the second quarter of 2017. Moving on to interest rates, average third quarter interest rate for new commercial loans was 4.3%, and as Don mentioned the average second quarter rate for total loans was 4.45%.

SBA 7(a) production in the third quarter totaled 8 loans for $6.1 million and the pipeline ended the quarter at $14.4 million. This compares to the second quarter of 2017 when we closed 10 loans for $6.2 million and the pipeline ended the quarter at $15.9 million.

Consumer production during the quarter was $60.7 million, up from $53.3 million in the second quarter of 2017 and $35.5 million in the first quarter of 2017.

Third quarter branch retail loan volume comprised $27.9 million of the total, up slightly from $27.2 million last quarter and indirect loan volume was $32.8 million, which is up $6.7 million from the second quarter.

The growth in retail branch volume over the last two quarters is due to an increased emphasis on direct consumer lending, primarily home equity lines of credit, as we look to offset a planned lower growth rate in our indirect portfolio during 2017.

The mortgage department closed $39.8 million in new loans during the third quarter compared to $33.7 million of new loans in the second quarter and $50.5 million in the third quarter of 2016.

The mortgage pipeline ended the third quarter at $29.1 million, very similar to the $29.7 million at the end of the second quarter of 2017, but down from $53.3 million at the end of the third quarter of 2016. The current mortgage pipeline is comprised of 46% refinanced loans, 37% purchased loans and 17% construction loans.

This compares to last quarter's pipeline where refinanced business averaged 43%. I'll now turn the call to Jeff for an update on the Puget Sound Bank merger..

Thank you, Bryan. I just wanted to jump in and let you know that the Puget Sound Bank transaction's progressing as planned. We've spent the last 90 days working with the Puget Sound leadership team and their employees to develop a plan for the integration.

We have gotten to know the team -- we've gotten to know the team better in the process of working together. We're impressed with their capabilities as well as their business model and we've already identified several practices that we will probably bring to the Heritage Bank platform.

Our system conversion projects are underway and we expect conversion to occur in the second quarter of 2018. We're still trending toward the change of control in the first quarter of 2018. Also you may have noticed my comments in the earnings release about increased expense relating to senior staffing.

In the last 18 months, we've continued to strengthen our enterprise risk management team. Additionally you may have noticed in the recent press release that we also added a Chief Technology Officer in the last month.

Many of these new members of the team come from larger banks, which is part of our plan to continue to enhance the existing capacity and experience of our team to support our growth plans. We believe this effort is key to our future success. And now I'll turn it back to Brian Vance for update on capital management as well some closing comments..

Thanks, Jeff. I'll start with capital management. Our regular dividend payout ratio for Q3 was 37.1% and for the first nine months of 2017 it was 35.8% and comfortably within our suggested 35% to 40% payout ratio. As I previously mentioned, in addition to the regular dividend of $0.13, we have also declared a special dividend of $0.10.

This will be the seventh consecutive year in which we've paid a special dividend to our shareholders. We continue to believe our capital position sufficiently supports our balance sheet risk, our internal growth and potential future growth both organic and M&A.

Now some comments for the -- just sort of outlook for the balance of 2017, we continue to be optimistic about the overall economy of Puget Sound region for the balance of 2017 and for our continuing growth. Competitive pressures however are still present.

We continue to see aggressive pricing from all fronts as well as a few aggressively structured deals. Competitive pricing along with a slight increase in cost to deposits however primarily drove non accretive NIM lower by 1 basis point.

We remain committed to our core focus on credit quality, despite these competitive pressures, which is what continues to fundamentally drive our loan growth strategies and performance.

Additionally, commercial real estate construction continues to be robust in our markets due to the economic growth we're seeing but we continue to remain disciplined in managing our concentration risk which also impacts our growth. We remain comfortably under regulatory CRE concentration guidelines at approximately 253% of capital.

By design and strategy, our loan to deposit ratio has increased from 79.5% a year ago to 84.2% today or at the end of Q3. However, as we approach the 85% range our strategies will gradually move to maintain a loan to deposit range in a mid to high 80% range to a more concentrated deposit gathering strategy.

This deposit focused strategy has been developing for the past year or so as we have been anticipating an inflection in deposit outflows for our industry, coupled with increased competitive pressures and deposit pricing. Our pertinent strategy was primarily built around a deposit growth focus.

As Don mentioned previously, our overhead ratio improved quarter-over-quarter from 2.85% in Q2, to 2.76% in Q3 despite our increased expenses related to our Portland-Oregon expansion as well as merger related expenses of Puget Sound Bank.

We continue to expect M&A and activity in the smaller less than $1 billion range and we expect that we will remain active in this area.

That completes our prepared remarks today and I would welcome any questions you may have and once again I would refer to our forward-looking statement in our press release as we answer any questions that you may have. Cathy, if you would like to open the call for questions, I would appreciate it..

[Operator Instructions] And our first question will come from Jeff Rulis with D.A. Davidson. Go ahead please..

Question for you on the account consolidation those benefits, and the growth rates are pretty impressive.

I guess could you capture if that's more of a near-term pop in growth or it has that -- has some carry for several quarters may be talk about kind of the growth rates you would expect on fees?.

Jeff its Jeff Deuel. We've been very happy to see that play out. As you remember, we managed through the consumer product rationalization process towards the end of last year and then we did the business accounts, mid this year. I think we're probably at the right run rate now.

There may be still a little bit more left to come, but I think generally we're done. The other thing that I would add to that is that we also fully implemented our treasury services platform. We had acquired a new one and I think that that's contributing to it as well.

That platform gives us more insights into how our commercial accounts are priced and how we monitor and manage that. So the three pieces together are what's generating that fee income..

And Jeff this is Brian, I would just add to that. As Jeff indicated, I think we're comfortable in that the run rates today are sustainable as we move forward. So we're really pleased with the efforts and the results in that particular area..

One quick one back for Jeff, just on the deal closing in Q1, if you can kind of refine that, is it looking more earlier in the quarter or is there a timing that you'd throw out there?.

At this point we would be delighted to close end of January and that would be ideal for us. We just don't have full control over the timing at this point..

And maybe last one just on the -- Brian you talked about -- it's a dynamic situation obviously, you've got some pressure on the loan side or loan competition and you talked about your deposit strategy.

I guess expectations on core margin, not specifically, but just kind of your -- the balance of '18, how you look at that that core margin number?.

I invite Don to offer his comments as well. I guess that as I indicated I think these are industry issues that as we look to pressures in deposit growth areas, pressure on deposit rates. I think the industry is experiencing this and we're starting to see just the beginnings of that as well.

And as I said in my prepared remarks, we've anticipated this for the last year or so, and we've really been focusing on building our deposit growth piece. And as I said that was a primary focus of our Portland team. So we're also taking that strategy across the footprint.

We've got a very comfortable liquidity position or overall liquidity position where we are with the loan to deposit ratio and the ability to fund future growth. And while I'm very comfortable with that, I think the industry is faced with some pressures there that if -- that I think we need to pay attention to.

It's real and while we're seeing a little bit of increase on the deposit funding side, I feel very comfortable about our ability to manage deposit costs. And then hopefully we can start seeing a little bit of a lift on the loan yield side.

It's a little hard to predict because of the competitive pressures, but I feel pretty good about where we are on NIM going forward and Don, you've probably got some comments as well..

Sure. So as Brian said is that, yeah, we are seeing some pressures on -- competitively. I think especially from smaller banks that have higher loan to deposit ratios. So we're seeing that. We're doing what we can to keep the deposits and making some pricing exceptions, [thus] causing part of it.

Again we're all looking for our deposit growth to improve over the next few quarters and as a result of that happens then we will also need less borrowings and borrowings are more expensive than our deposits. So that would also help the margin.

At this time though, the yield curve, it actually kind of sagged a little bit, kind of mid-year and that kind of [expecting] some of our mid-year, I think loan pricing for the last quarter.

That picks up a little bit, it has over the last week or so, that can also help especially if we get the [indiscernible] in the five year term range, that can help too. So obviously some various dynamics going on there, but we're looking to either hold it or improve it as we get further into the year..

Thank you. Our next question is from Matthew Clark with Piper Jaffray. Go ahead, please..

Hey..

Good morning, Matthew..

Good morning.

How are you?.

Good..

Good.

Just on the loan growth front, I know you have talked about 6% to 8% is your goal, probably coming at -- in toward the high end of that range, but curious what -- how the pipeline looks right now? And given all the kind of competitive dynamics, is that 6% to 8% still doable next year ex- Puget Sound do you think?.

Hi, Matthew, this is Bryan McDonald. The pipeline at the -- and of course, the pipeline at the end of the third quarter was $312 million, that's down from $360 million at the end of the second quarter, but up from $248 million this time last year. $312 million is a healthy pipeline going into the fourth quarter..

Yeah and I guess -- this is Brian Vance. I guess maybe, Matthew in terms of your comments about '18, as I said we still feel very comfortable with the economic growth in the region, nothing has changed in that regard. As I mentioned -- in this, we're sounding like a broken record here, but it is -- its reality.

Our concentration management is a bit of a self-imposed regulator to our growth. We feel that's important from just fundamentally managing the risk in the portfolio. But I think that as we look at '18, I think we're still comfortable with the historical loan growth that we've been experiencing.

You asked ex-Puget Sound that would be my comment on ex-Puget Sound. But I think adding Puget Sound to the mix, I think, give this a bit of encouragement that we can develop some synergies there as we meld the two teams together and have what I believe will be a very strong platform in King County.

And I think that could give us a bit of a tailwind in '18 as well. So overall, yes, I think, we're still quite positive about the future growth opportunities..

Great.

And then any update on the Portland initiative and the traction there?.

Sure, Matthews. It's Bryan McDonald again. We have 8 FTEs, new FTEs that have joined since mid-May and we've got another commercial banker who has accepted an employment offer, will start -- and have given notice and will start at the beginning of November, first part of November.

And then we're continuing to recruit for a few additional positions in 2017, in terms of our milestones, in terms of loans and deposits. For competitive reasons we're not sharing the details on that, similar to one we had launched at Seattle, but I'll say similar to Seattle we are -- I had -- where we had hoped to be at this point.

And again we'll be adding to the extent that we continue to hit our production roles..

Great.

And then on -- you mentioned some additional expenses in the release, I guess, how do we feel about the run rate going into the fourth quarter on non-interest expense?.

This is Don. I think that our run rate is if you take out the Puget Sound bank merger costs that we have stated in the release, I think, the run rate is probably pretty good, is probably pretty close to that. So we feel pretty good about that. That may pop up a little bit but I think the run rate overall is pretty good..

Thank you. We'll go next to Jacque Bohlen with KBW. Go ahead please..

Hi, good morning, everyone..

Good morning, Jackie..

I'm curious as to why you may consider Portland a deposit strategy and why lending wouldn't -- I mean, obviously you will be doing some lending in there.

But why lending isn't part of that description?.

Well, again, I'll give you a big picture and Bryan can add in some more detail. It is not just exclusively deposit focus. We have hired and we'll continue to hire lenders.

But I think the team that we hired, have several very accomplished deposit gatherers with I think proven capabilities in that market area of managing fairly complex deposit relationships over across a variety of industries.

It was an opportunity that when we looked at, I will tell you that that has not been a designed focus in our organization to have specifically specific deposit gatherers.

But as we looked at the model, we really saw a lot of benefit there not only with their proven ability in the Portland market, but taking that strength across the footprint and not necessarily across the footprint but I will say in major economic areas that we do business in.

And you couple that with what our belief has been on just general deposit flows and the need to continue to grow deposits. And my belief that a community bank's primary valuation premise is built on the deposit funding side. And so we will continue to strengthen on that. So Bryan, you may have some additional thoughts as well..

Yeah. I would just add that as Brian said it's kind of a combination of the types of business that they're going after tend to be deposit [written] and just a resource allocation in terms of hiring specific individuals to go after deposits.

And in Portland, we're a little bit more balanced on our commercial team than how we're in some of our other offices. So certainly we're going after full relationships. It's just with the niches and the mix of clients. A number of these are very, very deposit rich..

Jacque, this is Jeff. The other thing that's very positive for us is not only is this new team a great cultural fit for us, they've been in that market for a long time and they're helping us understand how that market works and I think is a result of that.

Our supporting them has been able to enable them to do some really nice business pretty quickly..

Okay.

And do you see that being additive to fees as well as Jeff?.

Yes. Actually, yes we do..

Okay. And probably just slowly as it ramps up there..

Yes..

And that's really great color. Thank you everyone.

And then just one last one, the current and prepared remarks about switching the focus from indirect auto, to HELOC, if you could just provide us a few details as to any promotions you might be offering to achieve that? If there are any and then also part of the thought process behind the time you make that switch?.

Yeah, Jacque. We -- last year 2016, we were kind of running a mid 20% growth rate in the indirect and just in terms of managing the overall bank concentrations, no specific concern with indirect just wanted to maintain balance between the different loan categories.

So as we look to pull that back somewhat in 2017, we still wanted to grow the consumer mix, so we increased the focus on home equity looking at that. It's a good option for us to balance out the overall growth.

And we did run a campaign that started in the second quarter of 2017 and ran well into the third quarter and as a result of that had significant growth in our home equity business.

It will be interesting to -- we have been watching the funding rates on that -- on those lines that we closed through the summer and we're hoping for some additional dry activity through the fourth quarter..

You might speak to the general concessions that we -- what we offered in there..

It's really a discount on the appraisals, the primary or valuation, they are not always appraisals but it's a discount of upfront costs, which is similar to what a number of our competitors do, just to entice folks to move their home equity or to open home equity with Heritage..

Thank you. And next we have a question from Tim Coffee with FIG Partners. Go ahead, please..

As the transaction with Puget Sound moves along, are you still maintaining the same amount of deal cost that we talked about when the deal was announced?.

Yeah, I think we would, I think we're comfortable with both the deal cost and the cost savings that were suggested when we announced the deal..

Okay.

And Bryan, your comments on competition in the market place, is that having any negative impact on the fall out ratio within your pipeline?.

This is Bryan, I would say the pipeline numbers that we're recording are what we view as our 90 day pipeline, it ends up being extended longer than that in reality and so most of those competitive deals, often won't make the pipeline.

So it impacts the calling activity outside the pipeline, I will say mostly we do run into scenarios where we get close to closing and then get competitive pressure from whoever the incumbent bank is that the business is coming from. But that's always there and I wouldn't say we've seen material change on that front.

But the market is competitive, there is lots of activity in the market but it also continues to be quite competitive..

Yeah, Tim, I guess I would just add to that.

One of my comments -- in my prepared comments I talked about aggressive competition and I think that, when we're talking about the aggressive competition on a deal whether it be pricing, whether it be structure, those deals as Bryan just indicated, typically we don't even make it to our pipeline because we just see quickly see that it just does not fit our parameters and the deal is killed before it gets to the pipeline.

Once it gets to the pipeline, I think our pull-through rates are probably fairly consistent over the last several quarters.

So it's not without competitive pressures but I think we do a pretty good job of managing what goes in the pipeline and not putting deals in there that are not realistic either to fit in our credit culture or pricing or whatever the case might be..

That's helpful, thank you Brian. And then just to kind of follow that up on the indirect portfolio. I understand that you are [exiting] balancing out the different components of the loan book.

Has the credit quality that you've seen from the indirect portfolio held up to kind of where you were expecting them come into the year?.

Yeah, really well. Through 2016 and into 2017, the credit quality has been very good..

And very consistent. And I know that's an area that analysts are watching across the U.S. and we watch that very carefully as well. It's just the performance of the indirect portfolio. I'll go back even to the beginning of the merger, has performed consistently and substantially better than what I see portfolios across the U.S. performing..

And for us Tim it's always been highly employment related. So strong employment, somebody has as a job, they're making the payments. So if you have something that impacts employment, it usually shows up really quick in the past dues on that portfolio..

Okay. Great. Thank you. That’s great color. Those are all my questions..

Thanks, Tim. I appreciate it..

Thank you. [Operator Instructions] And we’ll go next to Tim O'Brien with Sandler O'Neill & Partners. Go ahead, please..

Good morning..

Hi, Tim..

First question, just to follow-up the comments you made about the close out of the pool and it was a $1.7 million in charge-offs, so it came -- they were kind of tied to that.

Are there additional pools that are nearing, I guess that same kind of accounting treatment and do you see something like that or more of that occurring here, I don't know in the fourth quarter of 2018?.

Tim, this is Don. We don't necessarily see anything on the horizon, doesn't mean it's not going to happen. There's -- I think we have two more pools where we have this potential situation, but one of the pools has numerous loans in it, so we don't see that happening. There is another one.

That has one loan in it, but the maturity isn't for a while in there, and so we are not expecting anything to happen there. So it doesn't mean that they won't pre-pay, I don't think they're quite as large as what we went through this time, but it is always something that kind of hits us and all at once when that pool closes.

But I think we just have a couple of potential situations but we don't foresee anything happening in the near future on those..

So do you have a pretty good sense of, given the pool that has one loan remaining and has a longer maturity, do you have a pretty good sense also, say that that loan pre-pay here in the fourth quarter of what the impact would be or is that an adjustment that you guys aren't capable of making just because they aren't -- how arcane the accounting is around that at this point? Can you forward look on that, a little, Don, or is that -- are you -- and whether or not you disclose to us, but is that something that you're able to do?.

We know the imbalance of the allowance within each of these pools, and I can't tell you, top of my head, the exact amount, but we are monitoring that, internally, yes, we are doing that. And so, we're aware of what those amounts are that -- there will be allowances that could possibly reverse, at least estimate at this point..

Is that something that would be worthwhile to disclose in your 10-K maybe for '17 as to give an indication of remaining allowances and remaining pools or something like that, just so investors can have a heads up on where there might be some noise?.

Well Tim, I'll look into that. We'll consider that..

And then the other question is, is it always going to be an adjustment to -- was it an anomaly that the adjustment hit net charge offs or based on the treatment that occurs for that one pool?.

No, Tim. This has happened once last year, I don't know if you remember that, I think we had a $1.2 million charge-off last year related to in one quarter, I think it was Q2 of last year related to this. Like I said, some pools don't have an allowance related to them. So when the pool closes, there's no impact.

But like I said I think we have two pools left that do have some allowance on that, that we may -- this may get impacted in the future..

And then shifting gears real quickly, what was the ending quarter balance of HELOCs and how much growth that you put on in the quarter?.

I don't think we have the balances -- the balances for -- it's in the consumer number in the release..

Yeah..

But the -- during the quarter, the total direct business was $27.9 million and actually, if you compare it to 2016, our total direct lending, was a little over $80 million year-to-date versus $51 million last year. Don's just pulling the number here. Its $90 million -- just over $94 million in outstanding HELOC balances as of the end of September..

And the rest is indirect auto by extension predominantly?.

Yes. There is some other types of consumer loans in that number, but it would be predominantly indirect..

And also the HELOC production that you put on, do you happen to have a weighted average rate? Do you guys think that that's generating a throwing off right out of the gate?.

We don't have that here with us..

Can you estimate it [by that]?.

Yes. The rates run from kind of the prime plus 0.25 range up to the prime plus 2 range. So it's a prime plus product..

Yes. Okay. Well, thanks for answering my questions..

Thank you, Tim. I appreciate it..

Thank you. And gentlemen, we have no one else in the queue. Please go ahead with any closing remarks..

Well, I appreciate everyone calling in today. I appreciate your interest in our company and we may be seeing you down the road with investor conferences that are may be coming up. But thanks for calling in today..

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