Heritage Financial Q3 Earnings Call Highlights

Key Points

• Operating momentum improved: Heritage Financial grew loans by $133 million and deposits by $148 million in the third quarter, while net interest margin expanded to 4.05%. Management expects mid-single-digit annualized loan growth in the next several quarters and further margin support from asset repricing.
• Credit risk increased: Non-accrual loans rose $16.6 million to just over $32 million, primarily due to a $11.8 million transportation-related commercial and industrial relationship. Criticized loans also increased, though net charge-offs remained low at 0.03% of loans on an annualized basis through nine months.
• Integration and capital actions advanced: The Kitsap Bank systems conversion was completed as planned, merger-related expenses declined, and the company achieved its 35% cost-savings target. Heritage repurchased $10 million of shares and authorized a new program for up to 5% of outstanding shares, but expects fewer buybacks amid higher commercial real estate concentration.

Heritage Financial NASDAQ: HFWA reported third-quarter operating trends marked by loan and deposit growth, expanding net interest margin and the completion of its Kitsap Bank systems conversion, while also disclosing higher non-accrual loans tied primarily to commercial and industrial relationships.

President and CEO Bryan McDonald said the Kitsap Bank conversion was completed in late September as planned. “The results were excellent,” McDonald said, adding that the company is now largely past the costs of maintaining both platforms.

Loans, Deposits and Margin Improve

Total loans increased by $133 million during the third quarter, supported by strong originations and additional advances on existing loans, according to Chief Financial Officer Don Hinson. Loan growth was partly offset by higher prepayments and payoffs.

Heritage’s loan portfolio yield rose four basis points from the second quarter to 5.76%, reflecting higher rates on new lending and the repricing of adjustable-rate loans. Commercial teams closed $388 million in new loan commitments during the quarter, up from $339 million in the second quarter and $316 million in the year-earlier quarter.

The company’s commercial loan pipeline ended the quarter at $399 million, down from $628 million in the prior quarter. McDonald attributed the decline to higher loan closings, the departure of seven low-income housing projects totaling $103 million from the pipeline, and tighter standards for including loans in the pipeline for forecasting purposes.

Of the seven housing projects that left the pipeline, McDonald said three were shelved by borrowers and four were lost to competitors that offered better pricing. He said the lending market remained competitive, particularly as a more moderate volume of new opportunities led banks to price aggressively for business.

Loan prepayments and payoffs reached $207 million in the third quarter, compared with $152 million in the second quarter and $119 million in the first quarter. McDonald said the elevated payoff activity constrained growth but also indicated that customers had been able to sell businesses and real estate.

Based on its pipeline and unfunded commitments, Heritage expects annualized loan growth in the mid-single-digit range over the next couple of quarters. McDonald said visibility is strongest through the fourth quarter and first quarter, while the outlook beyond that period is less certain given interest-rate movements and payoff activity.

Total deposits increased $148 million in the third quarter, while non-maturity deposits rose $190 million. Hinson said the third quarter is typically seasonally strong for deposits, and new customer additions also contributed to growth.

The cost of interest-bearing deposits declined to 1.65% from 1.67% in the second quarter, though Hinson said the company likely reached an inflection point as deposit costs increased during the quarter. The spot rate for interest-bearing deposits was 1.66% at the end of September.

Net interest income increased $2.4 million from the preceding quarter, driven by higher average earning assets and an improved net interest margin. Net interest margin expanded to 4.05%, from 3.99% in the second quarter and 3.64% in the third quarter of 2025.

McDonald said higher five-year interest rates have increased the asset-repricing tailwind for the company. Heritage expects that dynamic to support further increases in both net interest margin and net interest income.

Credit Metrics Show Higher Non-Accrual Loans

Chief Credit Officer Tony Chalfant said non-accrual loans increased $16.6 million during the quarter to just over $32 million, representing 0.55% of total loans. That compared with 0.27% at the end of the first quarter and 0.44% at year-end 2025.

The main driver was one commercial and industrial relationship totaling $11.8 million involving several transportation companies. Chalfant said economic stress had contributed to ongoing delinquency issues for those businesses. The relationship includes more than $4.4 million of government guarantees, while the broader group of new non-accrual relationships includes $10.2 million in government guarantees.

Most of the remaining increase in non-accrual loans stemmed from three additional C&I relationships moved to non-accrual status because of delinquency issues. Chalfant said management viewed the larger transportation relationship as being in the earlier stages of workout, while the companies remained operational. He said the other relationships carried very limited loss potential, with one loan closer to liquidation resulting in a $91,000 loss.

The ratio of non-performing assets to total assets rose to 0.39% from 0.19% in the second quarter. Criticized loans increased $15.9 million to $246 million, or 4.19% of total loans, compared with 4% in the prior quarter. The increase was primarily associated with two C&I construction-related relationships and a multifamily construction project experiencing a slower-than-expected lease-up period.

Heritage recorded a $2.3 million provision for credit losses, reflecting strong loan growth and specific reserves for loans placed on non-accrual status. Hinson said about $1 million of the provision was attributable to the newly non-accrual loans.

Net charge-offs remained low at $381,000 for the quarter after $405,000 of charge-offs and $24,000 of recoveries. Through the first nine months of the year, net charge-offs totaled $1.2 million, or 0.03% of total loans on an annualized basis.

Expenses, Capital and Buybacks

Non-interest expense declined $2.4 million from the second quarter, primarily because merger-related expenses fell by $2.3 million. With most merger-related costs recognized, Heritage expects expenses of $55 million to $56 million in the fourth quarter.

Hinson said the company achieved its previously announced 35% cost-savings target related to the transaction. However, he expects core expenses to rise as compensation, benefits, payroll taxes, medical premiums and third-party costs increase.

The company also expects costs tied to a commercial online banking conversion, including about $500,000 in the fourth quarter and approximately $1.5 million in each of the first two quarters of 2027. Hinson said the project should be completed by mid-2027.

Heritage’s tangible common equity ratio was 9.3% at the end of the third quarter, down from 9.7% in the prior quarter, primarily because of increased net unrealized losses in the available-for-sale investment portfolio. Regulatory capital ratios remained above well-capitalized thresholds.

During the quarter, Heritage repurchased 341,000 common shares for $10 million and substantially completed its prior authorization. The board approved a new repurchase program covering up to 5% of outstanding shares, or about 2 million shares. Hinson said the company expects to be less active with buybacks in the fourth quarter, citing its commercial real estate concentration ratio, which rose to 308% from 300% in the second quarter.

About Heritage Financial (NASDAQ:HFWA)

Heritage Financial Corporation NASDAQ: HFWA is a bank holding company headquartered in Olympia, Washington. The company operates primarily through Heritage Bank, a community-focused financial institution serving businesses, individuals and organizations in Washington and Oregon.

Heritage Bank provides commercial and residential real estate lending, business and consumer loans, deposit accounts, cash-management and treasury services, online and mobile banking, and other traditional banking products.

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