Heritage Financial Corporation (NASDAQ:HFWA) is a bank holding company that primarily engages in the business activities of its wholly-owned subsidiary, Heritage Bank. The company provides financial services to local communities, with a strategic focus on commercial banking relationships, market expansion, and asset quality.

Financials

In the fiscal year 2023, Heritage Financial Corporation reported annual net income of $61,755,000, annual revenue of $303,128,000, annual operating cash flow of $109,523,000, and annual free cash flow of $99,147,000. The company's solid performance in the second quarter of 2024 showcased its ability to navigate the challenges of the current rate environment through active balance sheet management and expense control initiatives.

Second Quarter 2024 Performance

During the second quarter of 2024, the company reported a slight decrease in net interest income due to a rise in the cost of interest-bearing deposits, which outpaced the increase in yields on earning assets. The net interest margin declined to 3.29% in Q2 2024 from 3.32% in the prior quarter, primarily due to the rapid increase in the cost of interest-bearing deposits and a 48 basis point rise in the cost of borrowings. Management expected the margin to bottom out in the low to mid-3.20s before the end of the year as both the cost of deposits and deposit balances stabilize, and the company benefits from the repricing of adjustable-rate loans and higher origination rates on new loans.

Loan Growth and Deposit Trends

Loan growth remained strong in the second quarter, increasing by $104.5 million, or 9.5% on an annualized basis. The growth was driven by a $25 million mortgage loan pool purchase and $44 million in net advances on existing loans, primarily in the construction loan portfolio. Management expected the loan growth rate to average low single digits for the remainder of the year, as the company was unlikely to do additional mortgage pool purchases and anticipated higher construction loan payoffs.

Deposit balances showed signs of stabilization during the quarter, with average total deposits increasing by $29 million from the prior quarter, despite a $17 million decrease in focal day deposits. The company continued to experience a shift in the deposit mix, with nonmaturity deposits decreasing by $120 million and certificates of deposit (CDs) increasing by $104 million, $30 million of which was in the form of additional brokered CDs. Management expected the cost of the company's core deposits to continue increasing, albeit at a slower pace, as market pressures related to deposit rates persisted.

Credit Quality and Risk Management

The company's credit quality metrics remained strong and stable in the second quarter. Nonaccrual loans totaled $3.8 million, or 0.08% of total loans, and the company did not hold any other real estate owned (OREO). Criticized loans, those rated special mention and substandard, increased by a modest 2.2% during the quarter to $176 million, with the largest driver being the downgrade of a single $15 million multifamily construction loan. The company's consistent and disciplined approach to credit underwriting and concentration management has served it well in navigating various business cycles.

Balance Sheet Optimization

To defend its margins from downward pressures and reposition its balance sheet, the company executed a loss trade during the second quarter, selling $39 million of securities at a loss of $1.9 million. Management estimated that the annualized pre-tax income improvement from this loss trade would be approximately $1 million, resulting in an earn-back period of about 2 years. The company planned to continue considering additional loss trades to further optimize its investment portfolio and free up funds for other balance sheet initiatives.

Expense Management

Noninterest expense decreased in the second quarter due primarily to lower compensation expense, as the company had a lower full-time equivalent (FTE) count of 748 compared to 765 in the prior quarter. The company recognized $1.1 million in severance costs in the first quarter as a result of staff reductions.

Capital Position

Heritage Financial's capital position remained strong, with all regulatory capital ratios comfortably above well-capitalized thresholds. The company's tangible common equity (TCE) ratio was 8.9% at the end of the second quarter, up slightly from the prior quarter. The strong capital ratios allowed the company to be active in loss trades on investments and in stock buybacks, with 236,000 shares repurchased during the second quarter at a weighted average price of $18.19, or 104% of June 30 tangible book value per share.

Outlook

Looking ahead, the company remained focused on growing loans and deposits, while maintaining a sharp eye on expenses. Management expected loan growth to average low single digits for the remainder of the year, driven by continued strength in the commercial lending portfolio. The company planned to continue exploring opportunities to optimize its balance sheet through strategic loss trades and other initiatives aimed at defending its net interest margin.

Conclusion

Despite the challenges posed by the current rate environment, Heritage Financial's solid risk management practices, strong capital position, and prudent strategies positioned the company well to navigate the road ahead. The company's commitment to serving its local communities, coupled with its focus on commercial banking relationships and asset quality, underscored its resilience and potential for long-term success.