Ladies and gentlemen, thank you for standing by. Welcome to the Heritage Financial Earnings Conference Call. At this time, your telephones lines are in a listen-only mode. Later there will be an opportunity to question and answers and instruction given at that time. As a reminder, our call today is being recorded.

I'll now turn the conference call over to your host, President and CEO, Jeff Deuel. Please go ahead..

Thank you, Alan. Welcome to all who called in and those who may listen later. This is Jeff Deuel, CEO of Heritage. Attending with me are Don Hinson, our Chief Financial Officer; Bryan MacDonald, our Chief Operating Officer; and Tony Chalfant, our Chief Credit Officer.

Our earnings release went out this morning premarket, and hopefully, you have had the opportunity to review it prior to this call. We have also posted an updated fourth quarter investor presentation on our Investor Relations portion of our website. Please refer to the forward-looking statements in the press release..

Thank you, Jeff. As reported in our earnings release, we recognized earnings of $0.66 per share in Q4 compared to $0.46 in Q3. We also reported a $3.3 million or 15% increase in our pretax pre-provision income from the prior quarter. Before digging further into the income statement, I'm going to start by reviewing the balance sheet. Starting with loans.

Our loans receivable decreased $198 million from Q3. This decrease was due mostly to $153 million decrease in SBA-PPP loans as a result of the forgiveness process. In addition, we had decreases of $32 million in consumer loans and $17 million in C&I loans.

The decrease in C&I loans balances was due mostly to a decrease of $13 million in two large relationships. Consumer loan balances are decreasing primarily due to indirect auto loans, which we ceased originating early in 2020. Indirect auto loans decreased $27 million in Q4, and we expect that will approximate the runoff in future quarters.

Bryan McDonald will discuss loan production in a few minutes. Deposits decreased $91 million in Q4 due primarily to a decrease of $96 million in 1 public deposit relationship. This was an investment account for the public entity as opposed to an operating account, and we decided not to pay the higher rate due to our significant liquidity position.

Moving on to the allowance for credit losses. In Q4, we recognized a reversal of provision for credit losses in the amount of $3.1 million compared to a provision of $2.7 million in Q3, which favorably impacted pretax income by $5.9 million quarter-over-quarter.

The total reversal of provision for Q4 included a reversal of provision for unfunded commitments in the amount of $341,000. At the end of Q4, the allowance for credit losses on loans was 1.57%, which is unchanged to the percentage at the end of Q3.

Excluding PPP loans, which are guaranteed and not provided for, the allowance for credit losses on loans was 1.87% at December 31, a decrease from 1.93% at September 30. This lower allowance percentage was due to a decrease in allowances on individually evaluated loans as well as slight improvements in the economic forecast from the prior quarter.

Due to various factors, including government stimulus programs, charge-offs in 2020 have been lower than we originally thought they would be at the end -- at the beginning of the pandemic. Net charge-offs for 2020 were only 7 basis points.

The magnitude of future provisions will be dependent on a combination of factors, including economic forecasts, charge-off experience and loan growth. Tony Chalfant will discuss credit quality metrics in a few minutes..

Thank you, Don. Regarding credit quality, our net charge-offs for the fourth quarter were $363,000 and this was primarily attributed to the partial charge-off of a commercial construction loan that was impacted by cost overruns and construction delays.

Net charge-offs for the year totaled $3.2 million, which was very similar to what we experienced in 2019. We also experienced an increase in nonaccrual and potential problem loans due to the continuing impacts of COVID-19..

Thanks, Tony. I'm going to provide detail on our fourth quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $140 million in new loan commitments down from $181 million last quarter and down from $306 million closed in the fourth quarter of 2019.

The commercial loan pipeline ended the fourth quarter at $413 million up 7% from $386 million last quarter and up from $390 million at the end of the fourth quarter of 2019.

New loan demand continues to be negatively impacted by COVID-19, but our bankers report increased discussions with customers on capital projects, expansion plans and bank transitions, causing us to be cautiously optimistic this will translate into a higher loan volume in the second half of the year..

Thanks, Brian. As I mentioned earlier, we're pleased with our performance to date. Our primary concerns remain with borrowers in the high-risk loan categories, which is not news. These businesses make up the vast majority of the increase in nonaccrual and potential problem loan categories.

As in the past, you will see these loan categories ebb and flow quarter-to-quarter as we work with our customers. I encourage you to focus on net credit losses, which historically have been relatively low due to our conservative risk profile and much discussed concentration management system.

While we are feeling better about the big picture at this point, we are still facing several uncertainties around the vaccines, the economy, the political climate and ongoing social unrest in several of our core metro markets, which could potentially impact our performance.

However, for now, we're comfortable with where we sit, and we believe the impact of the pandemic on our loan portfolio will be much more subdued than we originally anticipated.

As Don mentioned earlier, we believe our current capital levels are adequate and our robust liquidity provides us with a solid foundation to address challenges and also take advantage of opportunities.

We are focused on what we can control, including managing risk, managing expenses, and continuing to develop the technology we need to deliver consistent long-term performance. That is the conclusion of our prepared comments. So Alan, we are ready to open up the call now and welcome questions that any of you may have..

Our first question will come from the line of Matthew Clark with Piper Sandler. Go ahead..

Maybe if we could just start on the expense run rate and kind of the technology reinvestment needs and the things you're working on this year.

I guess how should we think about the puts and takes around expenses?.

Matt, let me give you some color on that. I will say just as a reminder, our Q4 expense run rate tends to be the lowest of the year, and our Q1 tends to be the highest. So it basically goes -- first couple of quarters are higher and they tend to drop down based off various factors.

So speaking of that, we actually have some -- obviously, a lot of exit costs associated with branches in Q4. We also are going to have some savings associated with not having those branches in Q1, mostly realized in Q2. We do have a few exit costs left. But we are -- we do have technology.

We also are having some expenses associated with the forgiveness, for the new originations of PPP. So those are going to there'll be some expenses in there.

So looking ahead, I foresee that because of these expenses we didn't have last Q1 that we're having savings at the same time that we're probably going to be kind of close to where we were last Q1, kind of net out, but still will depend on various factors as far as how much we do have to spend on the PPP process..

And just to clarify, I mean, you're talking about that $37 million run rate a year ago, excluding exit costs, which we'd likely back out?.

Well, I'm saying that all net will be closer to the next -- to Q1 of last year then we were to Q4 or even Q3 of this year. So to net it all out..

Got it. Okay. And then just on the opportunities to higher teens in your markets, it sounds like there's a fair amount of disruption in the Northwest.

Are you in talks with anyone these days? Are you at a point where you're close to hiring some bankers here in the near term?.

Well, Matt, you know from prior conversations that we're always open to consider high-performing teams joining us, and we've successfully done that both in Seattle and in Portland. We're typically always in conversations with folks in the industry, whether they be people may be looking for a change or, quite frankly other banks.

So it's really up to us to determine the timing because up till now, we've been reluctant to bring on teams with all the uncertainty around us. And I think it's possible that we could do something this year, but we haven't been rushing to do it because we're waiting for everything to settle down first..

Okay.

And then just on the M&A side of the equation, can you give us an update there? Have conversations started to pick up more meaningfully? And do you expect to get something done this year?.

Much like everybody else, we are hopeful that there will be more activity as the year progresses, probably more in the latter part of the year. But we've been pretty diligent throughout the whole covet experience, keeping in contact with people we know in the industry.

So they can see how we're doing and what we're up to and that has served us well over the past couple of years in terms of keeping people informed so that if they decide to do something, we get a call. I think the conversations may have gotten a little bit more interesting in the last month, but I wouldn't say it's significantly different..

Okay.

And then, Don, can you just give us the remaining amount of net net PPP fees left from round one?.

Yes. I think it's a little over $15 million..

We'll go next to the line of Jeff Rulis with D.A. Davidson. Go ahead..

One question for -- I wanted to follow-up, Don's, just to clarify the expense number.

You're saying that, that's closer to Q1 of '20 versus Q4 of '20? And then given what you said typically, so confirming the balance there? And then the trend of that would be, it falls off from the Q1 level of '21 through the balance of '21?.

Yes. Jeff, I'll try to clarify that. So yes, I expect expenses to be closer to Q1 of '20 for the next couple of quarters based off the costs. And hopefully, we can continue to work that down over time. But I do expect it to be close to Q1. Based off offsetting factors that always hit us in the first part of the year..

Yes. Got it. Trying to strip out the -- some of the exit costs, but that's helpful..

The factors the name, but I'm just trying to give you an overview of that. So --.

No, I appreciate it, Don, the branch closures of what you've identified or what you've closed, probably a smattering of decisions there. But I don't know if there was a guiding -- you base that judgment off of profitability, metro versus rural, proximity of the other branches.

Was there some themes of what you're looking to pull from the network?.

I think what you primarily saw us do, Jeff, was rationalized branches that were close to other -- it was based on proximity for the most part. And I think that is partially a result of some of the new view we have had this year into our customers' activities.

A lot of people obviously signed up for online and mobile, and we're realizing that the number of branches is it does not need to be as robust as it used to be. And we'll continue to look at the rest of the footprint. And I suspect, over time, you will see us continue to chip away at the big broad footprint that we have, where it makes sense..

Okay. And Jeff, the reinstatement of the buyback, does that -- is that dark in the view of sort of M&A prospects? Or is it simply just a we got to keep that tool back up and accordingly, use it. Just I guess we shouldn't overreact to that being reinstated.

It's more a product of some comfortability about the macro environment?.

Yes. I think that was a good way of putting it. It's just 1 of the tools we have and in the right circumstances, we want to be able to use it. And if it makes sense. But no, I don't think you should overreact to us announcing that we're bringing it back.

Don, anything you want to add to that?.

No, I think you covered that..

Okay. And last one, just maybe for Bryan. It seems you've got a little kind of creep in the NPA figure, but with the recapture, my guess is those that migrated to nonaccrual were certainly on watch and reserve for? And just understanding that the direction of the reserve is more indicative of growing comfort than maybe watching the NPA level.

Anything you could expand on kind of reserve levels and additional release into '21?.

Don, maybe you want to take the reserve piece and then maybe Tony comment on credit quality..

I apologize. I mean, Tony, sorry about that..

No problem..

Yes. So I'll talk about the provisioning. As I mentioned, Jeff, it's just what -- there will be a lot of factors, including what kind of loan growth we have. But as far as the current increase in NPAs, even though they were added, there wasn't a required provisioning for those because of the collateral valuation on them.

So we felt pretty good about not adding any for those. Obviously, we're going to watch carefully the -- what's goes on in the economy, especially our industries that are -- have more challenges than others. We thought there was more favorable outlook quarter-over-quarter.

We did not -- at the current level of what's going on in the local economy, we just didn't feel like we could have released too much. Obviously, there some had to happen because of nothing else, the loan balances, but we didn't feel it was right to release too much of that currently.

But I can see that if we continue not to have charge-offs, at some point that will -- the provisioning will have to come back in. But it's hard to say whether the charge-offs are just postponed or they're really not going to be nearly as high as we have initially thought. So -- but it's kind of early in the game.

And I don't know, Tony, do you want to add any more to that?.

Yes. Thanks, Don. Yes, Jeff, just to answer to your question. I think if I don't answer it correctly, let me know, but -- or what you're looking for. But I feel like we -- the bank had pretty much the identified all the credits that were really at risk. All the loans were early at risk by the end of the second quarter.

And so really, the second half of the year has been largely just managing that portfolio and watching the more impacted borrowers migrate to the worst risk rating categories, including, of course, special mention, substandard and then obviously looking at nonaccrual and TDR situation.

So we feel pretty good at the end of the year with that portfolio has identified segmented properly. And as we move forward, it's just a matter of managing maybe a much smaller population of loans than we might originally thought we'd have earlier in 2020..

We'll go to the line of Jackie Bohlen with KBW. Go ahead. .

I apologize if this is a little bit technical of a question, but what kind of an effect did the decline in indirect auto have on the release this quarter from the provision standpoint? Just broadly, if it was a factor as well..

Jackie, you can just probably take the provision expense we have. I don't think it was it might have a higher percentage. I don't remember off the top of my head, what percentage we're applying to indirect auto, probably higher than what we've gotten there at 2% because it's much higher than, say, commercial real estate.

I don't remember exactly what it was. But if you take that decline in balance of $27 million and take it, say, it might be 3%, might be closer to what we allow for that might be an impact on that..

Okay. I mean, I guess where I'm going just broadly is wondering if part of that portfolio being in runoff mode, absent any other changes, is going to cause the ratio itself to kind of gradually trickle down as the risk profile shifts a little bit..

I would say marginally, but we're also down to about $200 million for the whole portfolio. So it will have less and less of an impact..

Okay. And then the two C&I loans that were called out as having the decline in the quarter, the two significant relationships. Was that intentional or was that driven by something else? In function on your part..

Yes. Actually, Bryan, you might have a better idea on that. That's the ones that paid off in the quarter that the larger relationships..

Yes. Jackie, this is Bryan. We did have elevated payoffs and pay downs in the quarter. And both of the large ones I'm thinking of were both business sales but we also had some refis, which wasn't those two, but that was the other big driver kind of coming back in perhaps just as the economy as people have a little better visibility.

Of course, rates are very low. So we didn't see a lot of refi activity, obviously, in Q2 or Q3, but we saw more in Q4 and then a resumption of some of the business sales we were seeing last year..

Okay. And I mean, just based on the pipeline numbers you gave, it sounds like setting payoffs aside from an origination standpoint, it sounds like you're fairly well situated into the year.

And then maybe more optimistic for a pickup as things start to open up, hopefully, in the latter half? Is that a good characterization?.

That's true. Right now, of course, we've got everyone focused on getting their customers through PPP, although that was a much shorter I guess, window of time where we are fully focused on it.

We're already well over the high point and this week, closing a lot of loans, but by the time we get it next week, I think we won't be back to normal because we'll still be working on it, but much less of a focus and with the vaccine rollout and the economy continuing to open up, we do see the second half of the year with a lot more potential..

Jackie, you know that you will probably never hear us use the term exuberance in terms of our future outlook. But I do want to remind everybody that under the overlay of COVID-19, the region was performing at a pretty high level before the pandemic, and there's still a lot of activity going on underneath the surface.

We just saw a new article about the Seattle market being in the top 10 most active economies in the country. I realize that were overshadowed with the pandemic. But when that starts to -- we start to be relieved of that pressure, there's a lot of potential in this region. And remember that in the metro markets, we're still relatively new.

So there's still a lot of work to be done there. And also not to forget when we did PPP 1 we got a good chunk of new prospects out of that, and they're still coming across the transom. It's not been a quick close because of everyone being remote and being distracted with where they are.

So -- and on top of that, we've got Microsoft and Amazon are still building and buying all over the footprint. So -- and housing prices are still very strong here you know that. So I think all of those things point to that cautious optimism that Bryan talked about in the second half of the year, if we get the vaccine going in the right direction..

Jackie. This is Don. Just while others were talking, I did check in about $500,000 of the release this quarter was due to the decline in indirect auto balances..

We have no further questions in queue at this time..

Well, if there's no more questions, then we'll wrap up this quarter's earnings call. Thank you all for participating. We appreciate your support and your interest, and I think we're going to see or at least talk with some of you in the coming weeks. So looking forward to that. And thank you very much for joining us..

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