Heritage Financial Corporation Stock

Thank you for standing by. My name is Kate, and I will be your conference operator today. At this time, I would like to welcome everyone to the Heritage Financial 2026 Q2 Earnings Call. [Operator Instructions]

I would now like to turn the call over to Bryan McDonald, President and CEO. Please go ahead.

Thank you, Kate. Welcome, and good morning to everyone who called in or those who may listen later. This is Bryan McDonald, CEO of Heritage Financial. Attending with me are Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer.

Our second quarter earnings release went out this morning pre-market, and hopefully, you have had the opportunity to review it prior to the call. In addition to the earnings release, we have also posted an updated second quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity and credit quality. We will reference this presentation during the call.

As a reminder, during this call, we may make forward-looking statements, which are subject to economic and other factors. Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within the earnings release and the investor presentation.

A couple of items to highlight as we look forward. The integration with Kitsap Bank is progressing as planned. We are converting systems late September and will be carrying higher expenses until after the conversion. Don Hinson will provide additional color on our estimated expense levels post conversion in a few minutes.

The second quarter net interest margin increased 3 basis points to 3.99% or 8 basis points if you adjust out the interest recovery that contributed to a higher margin in the first quarter. We expect the upward trajectory to continue but at a more moderate pace, primarily driven by new loans and repricing within the existing loan portfolio.

We'll now move to Don, who will take a few minutes to cover our financial results.

Thank you, Bryan. I will be reviewing some of the main drivers of our performance for Q2 as I walk through our financial results. Unless otherwise noted, all the prior period comparisons will be with the first quarter of 2026.

Starting with the balance sheet. Total loan balances increased $26 million in the second quarter. Loan originations increased in Q2, but elevated prepayments offset much of this higher production. Q2 yields on the loan portfolio were 5.72%, which was 1 basis point lower than Q1. This slight decrease was due to the recovery of interest on nonaccrual loans in Q1, which positively impacted loan yield by 6 basis points for that quarter. Bryan McDonald will have an update on loan production and loan rates in a few minutes.

Total deposits decreased $210 million in Q2 due to the seasonal decline that occurred in April related to tax payments and a $67 million decrease from a single deposit relationship who had deposited the funds on a short-term basis in Q1 and withdrew the funds in Q2. In addition, brokered CD decreased by $48.5 million during the quarter as borrowing rates were more attractive than brokered CD rates during the quarter.

The cost of interest-bearing deposits decreased to 1.67% from 1.71% in the prior quarter. This decrease was due mostly to having a full quarter of the impact of the merger with Olympic Bancorp compared to just 2 months in the prior quarter.

Investment balances decreased $36 million from the prior quarter due mostly to prepayments and maturities. During the quarter, we executed a small loss trade in which we sold $38 million of securities at a pretax loss of $217,000 and reinvested the proceeds into higher-yielding securities. The yield on the investment portfolio increased 11 basis points due mostly to having a full quarter impact of acquiring the Olympic portfolio at current market yields.

Moving on to the income statement. Most categories increased from the prior quarter due to the merger as Q2 was the first full quarter of combined operations. I will cover a few areas of note. In addition to the impact of increased average earning assets due to the merger, net interest income also benefited from an increase in the net interest margin. Net interest margin increased to 3.99% from 3.96% in the prior quarter and from 3.51% in the second quarter of 2025. The increase was due primarily to the increase in yields on the investment portfolio and a decrease in the cost of deposits. The previously mentioned recovery of interest on nonaccrual loans in the first quarter had a 5 basis point impact on the margin performance for that quarter, which muted net interest margin growth quarter-over-quarter.

We recognized a reversal of provision for credit losses in the amount of $921,000 in Q2. This reversal was due primarily to adjusting the allowance on loans from 1.06% at the end of Q1 to 1.03% at the end of Q2. This decrease in the allowance percentage was due to factors such as the decrease in weighted average life of loans and a change in the portfolio mix. In addition, net charge-offs remain at very low levels. Tony will have additional information on credit quality metrics in a few moments.

In addition to the first full quarter of combined operations, the increase in the net interest expense was also due to merger-related costs of $7.5 million in Q2 compared to $5.2 million in Q1. Due to the fact that the systems conversion for Olympic is scheduled for late Q3, we expect elevated expense levels until Q4. Based on our current forecast of staffing levels and merger-related costs, we are remaining consistent with our guidance from last quarter in that we're expecting quarterly noninterest expense levels to be in the $64 million to $65 million range in Q3 before decreasing to a range of $56 million to $57 million in Q4.

And finally, moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds and our TCE ratio was 9.7% at the end of Q2 compared to 9.6% in the prior quarter. During Q2, we repurchased 372,000 shares of common stock totaling $10 million. We will continue to consider stock buybacks depending on market conditions and other capital priorities. We still have 424,000 shares available for repurchase under the current repurchase plan as of the end of Q2.

I will now pass the call to Tony, who will have an update on our credit quality.

Thank you, Don. I'm pleased to report that credit quality remained strong and stable through the first half of the year. Nonaccrual loans totaled $15.5 million at quarter end, increasing by a modest $500,000 during the quarter. This represents 0.27% of total loans and compares to 0.26% at the end of the first quarter and 0.44% at the end of 2025. Within the quarter, we downgraded 2 related C&I loans to nonaccrual due to their delinquency status. Both loans were fully repaid prior to quarter end. Within our nonaccrual loan portfolio, we have $4.2 million in government guarantees.

Due to the stability of our nonaccrual loan totals, the ratio of nonperforming assets to total assets was consistent with the prior quarter at 0.19%. We continue to hold a single-family residence as OREO with a book balance of $755,000. This house is currently listed for sale, and we've seen strong interest. We expect it to sell and close during the third quarter. This is the first OREO property we've held since 2020.

Criticized loans, those rated special mention or worse, moved modestly higher during the quarter by $5.5 million. As a percentage of total loans, criticized loans were stable at 4% versus the 3.9% that we experienced at both year-end 2025 and the end of the prior quarter. When looking at the more severe substandard category, we continue to see improvement during the quarter. Substandard loans to total loans declined to 1.8% at quarter end versus 2.4% at year-end 2025 and 2.1% at the end of the first quarter. Most of the $15.9 million decline during the second quarter came from payoffs or paydowns on 3 separate C&I relationships.

Our ratio of total nonowner-occupied CRE loans to total loans remained stable during the quarter at just under 300% versus 301% at the end of the first quarter. As a reminder, the increase in the first quarter was due to the inclusion of the Olympic portfolio and the fair value accounting for the acquisition. Specifically, the lower combined capital level from the fair value marks resulted in a higher total CRE ratio. We expect the ratio to continue moving down to historical levels over time.

During the quarter, total charge-offs remained low at $269,000. The losses were partially offset by $35,000 in recoveries, leading to net charge-offs of $234,000 for the quarter. Net charge-offs through the first 6 months of the year were $786,000. On an annualized basis, this represents 0.03% of total loans and is consistent with our performance for the full year 2025.

Page 18 in the investor presentation illustrates how our proactive management of problem loans has led to low levels of loan losses over the past 7-plus years. We are pleased with the stability in our credit metrics through the first half of the year. While the challenges in the economy have led to some pressure on certain segments of our C&I portfolio, the risk has been manageable. This is reflected in our continued low levels of nonaccrual loans and net loan losses.

I'll now turn the call over to Bryan for an update on our production.

Thanks, Tony. I'm going to provide details on our second quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $339 million in new loan commitments, up from $166 million last quarter and up from $248 million closed in the second quarter of 2025. Please refer to Page 12 in the investor presentation for additional detail on new originated loans over the past 5 quarters.

The commercial loan pipeline ended the second quarter at $628 million, in line with the $631 million reported last quarter and up from the $473 million at the end of the second quarter of 2025. Loan balances increased $26 million during the quarter, a relatively modest level considering loan closings were up 104% compared to last quarter. The growth was limited due to a couple of factors. Loan prepayments and payoffs increased to $152 million during the quarter versus $119 million in the first quarter. And the mix in the quarter included a higher level of construction loans where balances will increase over time.

Please see Slide 13 in the investor presentation, which shows construction utilization rates down 4.1% versus last quarter. Based on the current pipeline, we expect our annualized loan growth rate to be in the mid-single-digit range for the next couple of quarters.

Deposits decreased $210 million during the quarter. A second quarter decline in deposits is typical of our seasonality due to tax payments, although the 2026 decline was higher than last year due to a $67 million decline related to nonoperating funds in one commercial customer account, which Don mentioned a few months ago -- or a few minutes ago, and a $48.5 million decline in brokered CDs. Adjusting for these 2 factors, deposits were down 1.3% in the quarter compared to 1% during the second quarter of 2025.

Moving on to deposit production and pipeline. Average deposit balances on new deposit accounts opened during the quarter are estimated at $62 million versus $33 million last quarter, and the deposit pipeline ended the quarter at $78 million versus $102 million at the end of the first quarter.

Moving to interest rates. Our average second quarter interest rate for new commercial loans was 6.44%, which is up 36 basis points from the 6.08% average in the first quarter. In addition, the second quarter rate for all new loans was 6.40%, up 24 basis points from 6.16% last quarter.

In closing, we continue to see a tailwind from asset repricing benefiting our margin and believe we are well positioned to navigate what is ahead and to take advantage of the various opportunities to continue to grow the bank. With that said, Kate, we can now open the line for questions from call attendees.

[Operator Instructions] Your first question comes from the line of Matthew Clark with Piper Sandler.

I wanted to clarify the expense guide. The $65 million sounds like it includes merger charges. Can you just quantify the merger charges you expect in 3Q and in 4Q to get to that so we can have a kind of a core run rate?

Yes. I think when I mentioned that the Q4 being in the $56 million to $57 million range, that would be your run rate there going forward. So most of our merger expenses will be done in Q3. There may be just small minor things left over for Q4, but nothing material.

And how much is in the $65 million for 3Q?

Say that again, the $65 million?

How much in merger charges do you have in the 3Q guide of $65 million?

About -- well, again, I would say it's probably $64 million. So I think it would be similar to what it was probably in Q2, right? So I'm guessing we've got another $6 million there. And then, of course, we have just the systems that are -- by merger costs, we talk about things like contract cancellation fees, severance payments, those type of things. It doesn't include things like ongoing contracts that are -- that will cease those expenses. So the combination of why it goes down so much is the combination of the merger-related expenses going down as well as the contract costs or the FTE costs going down in Q4.

Got it. Okay. And then on the borrowing side of things, FHLB up to, I think, $166 million at the end of the quarter. It looks like they all mature in the third quarter. What's the -- how should we think about FHLB borrowings when we forecast and given -- yes.

It's pretty much -- they all mature within the first 2 weeks of July, right? So it's just basically overnight or maybe we might go out a few weeks at a time just -- if we see a rate that we like as needed. But it's just as needed for liquidity purposes. In this case, we obviously saw some outflows of deposits in Q2. So this was -- and we let brokered CDs run off of $48 million. So those two things combined caused us to have some borrowings. If we get some nice deposit growth in Q3 as we normally do, I would expect those borrowing balances to decrease.

Yes. Got it. Okay. And then just on deposit costs, down nicely this quarter. I want to get your outlook there just with assuming the Fed is on hold for now and given the competitive environment?

Well, I think we hit the bottom. Our spot rate for interest-bearing deposits was 1.64% at the end of the quarter. And so I think we've probably hit bottom on that. I think there's a lot more competition for deposits. People are -- the rates are going up even in the short term. Obviously, the Fed hasn't raised rates yet, but CD rates are starting to increase the competition on those. We're starting to see more pressure on even some of the other rates.

So I think that we will see some gradual increases in cost of interest-bearing deposits from here on. So I think that's going to -- I think on the other side, I think we'll still get the increases on the yield on loans that will help us to continue to improve margin over time. But I think we're going to see some pressure on deposits.

Your next question comes from the line of Jeff Rulis with D.A. Davidson.

To circle back on the expense side. I guess to get from $65 million to $57 million 3Q versus 4Q, Don, I think you said $6 million is on merger costs and then maybe are we thinking $2 million in cost saves to get to the run rate. Is that right?

Correct.

And then I guess if we -- would you expect cost saves to be complete as of 4Q? Or is there any tail into '27? I know that's spread out, but...

Very little. Not enough to really give you guidance on.

Yes. Got it. Appreciate that. On the loan growth, mid-single digit for the remainder of the year. Does that assume a similar level of prepayment?

It does, Jeff. This is Bryan. A little higher last quarter and nothing unusual there, although we are seeing more customers selling businesses, which often involves sale of the collateral for the loans, that sort of thing. So we saw an uptick in that type of activity. And then in the portfolio coming across from Kitsap and just better visibility after close to the construction loans that were coming up and just meeting their maturity dates and paying off as usual.

So those were the couple of drivers of the higher payoffs in the quarter, and we are assuming those continue and with the pipeline being basically flat with last quarter, which was really strong, we feel like mid-single digits is a better indicator looking out over the next couple of quarters.

Got it, Bryan. I guess one last one on the margin then. It sounds still positive, but maybe less, not at the magnitude of the linked quarter, which I think if we back it out, it's maybe 8 basis points of core margin increase if you exclude the impact from the recovery interest. So I guess not to put a number on it, but just moderate that improvement, but positive nonetheless.

I think that's a good description of that. I think we're going to keep moving forward on the margin, but it won't be as strong as it was the prior quarter.

And Don, sounds more earning asset benefit, like as you said, kind of the benefit from the funding side or improvement, that's largely done. It's just when you scratch out gains, it's going to be on the earning asset or loan yield side?

Right. If you look at what we put the loans, the new loans on last quarter, what the -- we read that slide in our deck every time where it shows what they're repricing at, that's where we're going to get the lift.

Your next question comes from the line of David Feaster with Raymond James.

I wanted to touch on that increase in originations. That's extremely encouraging. Glad to hear the pipeline is still strong. Like that increase in originations, would you attribute that to more of an increase in demand or a function of increasing productivity and activity from your team? And then just we've talked a lot about competition, especially on the pricing front. Curious, your willingness to compete on pricing to drive growth just as kind of you philosophically balance NII growth versus margin.

Yes. And David, Slide 12 has some good detail on the categories of the new production. And in my comments, I just commented a bigger portion came in construction, and you see that on Slide 12. And so that was a chunk of it. Nothing new kind of relative to the categories that we're financing there.

To your original question, it's an increase in loan demand. I do think our sales teams are very active, very, very active. But we've seen loan demand increasing since last summer after the Big Beautiful Bill. And then as we came into 2026, we've seen the pipeline continue to strengthen. It's not every market and every banker across the board, but we had significant closing volumes and closed the quarter with a really strong pipeline. So that's the driver behind the volumes.

In terms of pricing and our willingness to compete there, we do look for the highest quality opportunities out there in the market. And so these customers have options to bank with a variety of different banks. And so we do regularly compete on price. That's not a new phenomenon, just kind of always present with that commercial client where you have the opportunity to take the full relationship.

So I wouldn't say significantly different. It just continues to be a very, very competitive market, and we're looking to win our share. We did see rates move up, but that was really driven by the underlying indexes moving up. That 5-year FHLB rate is what we price a lot of our term debt off of. And so that was really the driver behind the increase in rates on newly committed loans in the quarter just with the indexes moving up.

Okay. And then you guys have been very active and consistent managing the balance sheet and optimizing things, and that's clearly helped the margin. How do you think about additional opportunities as you look to defend the margin and maybe accelerate just optimize things?

Yes. And in Don's comments a minute ago, there's still significant upside in the margin from asset repricing. Our average note rate is 5.72%, and we put on new loans in the quarter at 6.40%. And then we also have significant upside in terms of rate resets on existing loans, and we have a slide in the deck.

So there's quite a bit remaining there, David, where every new loan that goes on or loan that reprices is going to be at a higher rate than what we have the loans on the books at, at least looking at things today. So that's a big driver. And then the loan-to-deposit ratio is also a really good opportunity to drive continued margin growth. Our loan-to-deposit ratio is still relatively low. So to the extent we can move that up a few percent, it's going to have a big impact on net interest income.

That's helpful. And look, there's been a decent amount of disruption across your footprint in both Washington and Oregon. I'm curious, do you see a whole lot of opportunity and have you on the client acquisition front or on banker dislocation? And just what's your appetite for new hires or lift-outs at this point?

Yes. We obviously had the combination with Kitsap that we closed in the first quarter. But outside of that, our last M&A deals were back in 2018. But Slide 10 of our investor presentation has detail on all the teams that we've added, and it's been a key to our growth strategy.

So yes is the answer. We're still out actively talking to talent. This year, it's -- since we did Spokane last year, we've continued to add to that team and then also done just banker additions across the market as talents become available. But we'd certainly be open to continuing that or doing additional teams if good talent becomes available either through industry consolidation or just otherwise through changes at their current institution. So I see that strategy continuing, David.

Your next question comes from the line of Andrew Terrell with Stephens Inc.

Not to belabor the topic, but I did want to go back to expenses just for a moment. I appreciate the guidance. If I kind of compare where you're talking a clean 4Q run rate, it doesn't seem like relative to the $18 million of annualized cost saves you were expecting with the acquisition announcement, it feels like you're maybe coming up a little bit shy.

So I wanted to ask, there's a lot of moving pieces here, but kind of in your models, where are you getting at in terms of cost save realization or cost save achievement relative to that initial target? And what are the moving pieces that we should appreciate that kind of maybe prevent us from fully seeing that coming out of the run rate?

Well, I think we're on the cost savings that we're going to be hitting that on from the merger. So if you're seeing us come up a little short in some of the realization, I think there could be just on the legacy Heritage side, some other costs that we've added in as a result. So I think that's where I'm getting the number, the total number at this also factoring that in.

Okay. Sounds good. And then I wanted to ask, I appreciate all the color around some of the deposit flows this quarter. Just wanted to get kind of your expectations around deposit growth in the back half of the year. Do you feel like you can kind of match that mid-single type loan growth? I know I heard some of the comments around some of the competitive dynamics in the market. Just would love to hear kind of your commentary on your willingness or desire to kind of compete and match fund loan growth.

Don, do you want to start and then I'll add some comments.

Yes. I think Q3 and somewhat in Q4, last half of the year is usually pretty good for us for deposit growth. Again, I would say, mid-single-digit annualized growth type of thing. So I don't see that changing this year. You never know until you get into it. I'm not noticing anything so far this -- so far in early Q3 that would change my mind on that. So I think we're going to probably have a strong Q3 and a decent Q4 is what we usually have in Q3 and Q4 is, again, Q3 our strongest and Q4 also having some growth. So I think that, that's what I'm expecting.

But until you get into it, it's really hard to say what will happen. We are going to be -- we'll be competitive on rates for deposits. So that shouldn't be a hindrance there. But if rates, if the market rates go up such as people, if they start looking for other funding outside of banks, whether it's going into other investments, that's something that's a little hard to control what they do with their excess funds.

And Bryan, I don't know if you want to add to that.

Yes. We looked really closely at all of the deposit flows year-to-date in part because of the drop in Q2. And really, it was all a lot of normal activity, perhaps with the exception of a bit elevated customer sale activity where a customer maybe sold a business in the first quarter and had significant excess funds in the account and/or sold it in the second quarter and ended up distributing the majority of the business, what used to be the business deposits out as well. But that wasn't a material driver of the activity in the quarter. It was just more of an observation.

So I tend to agree with Don. There is a lot of deposit competition out there, and we see that as we're bringing on new relationships. But we're traditionally going after those operating relationships, winning those. And really for the last couple of years, we've had to pay up for the excess funds on those relationships because we've been competing with a variety of other players and the customers are very aware of what's available to them in the market. So kind of those new dollars have been more expensive than what they've been in the past, but we have been competing for those relationships effectively for the last couple of years. So if rates go up, I think it will get more competitive, but I still see us winning the same level we have in the past.

Great. I appreciate all the color. And if I could just tack one on, are you able to quantify the -- I mean, you guys have a fantastic deposit franchise. I think you said 1.64% on the IBD spot costs at the end of the period. Are you able to quantify just for that kind of competitive new money you're bringing on the delta of an incremental dollar of deposit growth versus where the portfolio stands on an average basis today?

Don, I'm not sure if you have that. We've looked at it in past quarters, Andrew, but I'm not sure if we prepared it ahead of the call today.

Your next question comes from the line of Kelly Motta with KBW.

I apologize if this has already been asked. I dropped off by accident briefly earlier. But I did hear a lot of talk about the flexibility of your balance sheet. You clearly have room on the loan-to-deposit ratio, a strong amount of capital as well. Wondering, as you think about the potential ways to drive upside to the margin, how you're thinking about securities restructuring, buybacks and all those things to kind of unlock the power of your balance sheet further?

Don, do you want to take that first, and then I can add to it.

Sure. I think that we'll start with the last one you talked about, buybacks. Again, as I mentioned in my comments, initial comments, that we'll continue to be open to buybacks depending on, again, kind of market conditions and other capital needs, but it's certainly something that we're looking at and we'll continue to look at. So we could very well be just as active in Q3 as we were in Q2, but I'm not really trying to give you guidance there, just that we're not necessarily slowing down, but at the same time, we'll be looking at just what the market is giving us on that.

As far as other things that we did, like I said, we did a little bit of an optimization trade on the investment portfolio. We'll continue to look at, again, trying to leverage what's in the balance sheet that way. We don't have anything large planned at this time. And of course, we would be looking to -- again, the repricing of the loan portfolio is just going to be a big one. I think we will see some -- again, like I mentioned before, I think we will see some pressure on CD rates going into Q3 with the way the market is 1 year in on the rates. So I think that is going to be a challenge.

I'll now turn the call back over to Bryan McDonald for closing remarks.

Thank you. If there's no more questions, we'll wrap up this quarter's earnings call. We thank you for your time, your support and your interest in our ongoing performance, and we look forward to talking with many of you in the coming weeks. Goodbye.

Ladies and gentlemen, that concludes today's call. Thank you all for joining. You may now disconnect.

Hello, and welcome to the Annual Meeting of Shareholders of Heritage Financial Corporation. Please note that today's meeting is being recorded. [Operator Instructions]

It is now my pleasure to turn today's meeting over to Brian Vance, Board Chair. Brian, the floor is yours.

Thank you, Emily. Good morning, ladies and gentlemen. Welcome to the Virtual Annual Meeting of the Shareholders of Heritage Financial Corporation. I'm Brian Vance, Board Chair of Heritage. It's my pleasure to serve as Chair of this meeting.

Before I move to the business at hand, there are a few housekeeping items I will address related to today's virtual meeting. If you have not yet voted and wish to vote or if you wish to revoke a previously submitted proxy, you can click on the voting link contained within the information on the website. To vote your shares, you will need a unique control number provided on your proxy card. We've reserved time in the meeting later in the meeting for a question-and-answer session. You can submit questions at any time during the meeting by clicking the conversation chat button at the top of the screen. Please note your registered name will be announced along with the question. Non-shareholder guests are in a listen-only mode and will not be able to submit questions.

Please note that in the interest of all shareholders, we will only address those questions that are related to the matters that are being voted on at this annual meeting. We appreciate your understanding. For any general business questions about Heritage, please refer to the information available on the Investor Relations website, which includes our SEC filings. If you need a copy of the annual report or the proxy statements, the links are also provided online. We will strictly follow the agenda as we conduct the meeting. At this time, I call the meeting to order.

Joining me today from the Board are Directors, Brian Charneski, Lead Independent Director and Audit and Finance Committee Chair; Bryan McDonald, President and CEO; Scott Allan; Trevor Dreyer; Kimberly Ellwanger; Gail Giacobbe; Jeff Lyon, Compensation Committee Chair; Fred Rivera, Governance and Nominating Committee Chair; Karen Saunders and Ann Watson.

Also in attendance are the following members of our management team: Don Hinson, Chief Financial Officer; and Kaylene Lahn, Corporate Secretary. We also have Joseph Ceithaml, Legal Counsel with Barack Ferrazzano; Mike Wengel and Sarah Paxton from our accounting firm, Crowe; as well as Earon Crosby with our transfer agent, Computershare, in attendance today.

Now to the business of the meeting. Kaylene Lahn will act as the Secretary of this meeting. Shareholders who have already voted by Internet, telephone or mail need not vote again online at this meeting. Your voting instructions will be carried out this morning by the appointed proxies. They are myself and Brian Charneski.

The Corporate Secretary has informed me that at the time appointed for the commencement of this meeting, there are 35,351,951 shares of common stock represented in person or by proxy, representing 86% of the 41,131,100 shares held by shareholders as of the close of business on the record date, March 9, 2026, and entitled to vote. Therefore, a quorum is present for the transaction of business as required by the company's bylaws and applicable law. We will waive the reading of minutes of our last year's annual meeting, but a copy of those minutes is available upon request.

The Corporate Secretary has the list of the shareholders of the company entitled to vote at this annual meeting, showing the holders of the common stock of the company as of the close of business on March 9, 2026, the record date for voting.

We have previously received an affidavit that the notice of meeting and a form of proxy were mailed on or about March 20, 2026, to each holder of record as of the record date. A copy of these documents will be attached to the minutes of this meeting. The polls will close for voting on all items when discussion has been completed on the final item up for vote.

Since no shareholder nominations or proposals were filed in advance of this meeting as provided in the company's bylaws and applicable law, the business of this meeting is limited to the matters listed in the notice. We shall now proceed to vote on these proposals. You are entitled to 1 vote for each share registered in your name. The Inspector of Elections is making an exact count and will submit a formal report on the number of shares present or represented later in the meeting.

The first item of business to be voted on -- to be acted upon is Proposal 1, which is the election of directors. The Board of Directors has nominated 11 individuals, all of whom are incumbent directors to serve for a 1-year term as directors to expire at the 2027 Annual Meeting. I hereby declare Scott Allan, Brian Charneski, Trevor Dreyer, Kimberly Ellwanger, Gail Giacobbe, Bryan McDonald, Jeff Lyon, Fred Rivera, Karen Saunders, Ann Watson and myself, Brian Vance, duly nominated.

The company has not yet -- has not received timely notice of any other nominations by shareholders. Therefore, I declare nominations closed.

The vote will now be taken on the proposal. The election of our directors requires the affirmative vote of the majority of votes cast by shareholders, meaning that the number of shares voted for a director nominee must exceed the number of shares voted against nominee. If you have not already voted, please vote now utilizing the online platform in relation to the proposal on the election of directors. And I will pause just a moment for you to do so.

[Voting]

The next item on the agenda is Proposal 2, the advisory nonbinding vote to approve the compensation paid to our named executive officers. The vote will now be taken on the proposal. The approval of the compensation paid to our named executive officers requires the affirmative vote of the majority of shares of common stock present in person or represented by proxy at this annual meeting, although we note that this is an advisory vote only. If you have not already voted, please vote now using -- utilizing the online platform in relation to the advisory proposal on the executive compensation. I'll pause again.

[Voting]

The final proposal of the agenda is the ratification of the appointment of Crowe LLP as the company's independent registered public accounting firm for the fiscal year ending December 31, 2026. The vote will now be taken on the proposal. The ratification of the appointment of Crowe LLP must receive the affirmative vote of the majority of shares of common stock present in person or represented by proxy at this annual meeting. If you wish to vote using the online platform, please vote now on the ratification of the appointment of Crowe LLP as the company's independent registered public accounting firm for the fiscal year ending December 31, 2026. I will pause again, allow you a moment to vote.

[Voting]

We will now take any shareholders' questions related to today's agenda. As a reminder, you can submit questions by clicking the conversation chat button at the top of the screen. Non-shareholder guests are in a listen-only mode and will not be able to submit questions. As noted at the beginning of the meeting, we will only address those questions that are related to the matters that are being voted on at the annual meeting. Are there any questions?

We have not received any questions regarding the business before this meeting. So the question-and-answer session is now closed.

If you have not already done so, we remind you to submit your vote on each matter by clicking on the voting link contained within the information page on the website. Voting is about to be closed. I'll pause again for a moment.

[Voting]

As everyone has had an opportunity to vote, I declare the polls closed on all 3 matters presented for a vote at this meeting. That concludes the voting on the proposals to be considered at this meeting. The Inspector of Elections has completed the count, and I would like to have the Inspector of Elections, Earon Crosby, present to you the report of the inspector.

Thank you, Brian. The report of the inspector confirms that a quorum is and has been met at the annual meeting for all purposes. It also shows that 11 director nominees have each been duly elected directors of the company for a 1-year term. More than a majority of the shares present in person or by proxy at this annual meeting have been voted in favor of the approval of the advisory vote on the compensation paid to our named executive officers. Accordingly, the advisory vote on the compensation paid to our named executive officers has passed.

Finally, the report of inspector shows that more than a majority of the shares present in person or by proxy at this annual meeting have been voted in favor of the ratification of the appointment of Crowe LLP as the company's independent registered public accounting firm for the fiscal year ending December 31, 2026. Accordingly, the ratification of Crowe LLP as our independent registered public accounting firm for the fiscal year ending December 31, 2026, has passed.

Thanks, Earon. The inspector is directed to submit a certificate of inspector of elections to be filed with the Corporate Secretary for insertion in the company's minute book together with the minutes of this meeting.

I would now like to turn the call over to Bryan McDonald, the President and CEO of the company. Brian?

Thank you, Brian. I'm not going to recap 2025 or the first quarter of 2026 performance in detail and would like to direct everyone to our company website where you can find our earnings reports and investor presentations. I would, however, like to provide a high-level view on several aspects of our business.

Heritage continues to provide strong support in our local communities. During 2025, our employees participated in the fourth Annual Heritage Bank Volunteer Day, whereby the entire bank focused on one afternoon of volunteer time at local nonprofit organizations across the footprint. Collectively, our employees contributed 5,106 volunteer hours of their time and expertise to 541 local charities, schools and community events throughout 2025. Additionally, corporate contributions for 2025 were $1.18 million.

At last year's meeting, we described 2024 as a year of positive transition with our net interest margin and net interest income, both achieving quarterly increases. These favorable trends continued in 2025, incrementally driving higher in the fourth quarter. On an adjusted basis, diluted earnings per share were up 29% versus the fourth quarter of 2024. And on the same adjusted basis, our return on average assets improved to 1.29% versus 0.99% in the fourth quarter of 2024.

During the first quarter of 2026, we closed our acquisition of Olympic Bancorp and its subsidiary, Kitsap Bank. I would like to extend a warm welcome to both shareholders and customers joining Heritage through this combination. Kitsap brings to Heritage a strong market share in the communities it serves, excellent relationship-based core deposits and exceptional loan quality, all of which are complementary to Heritage's primary strengths. The combination with Kitsap improves the profitability of our company and expands our market share in the Puget Sound region.

Our net interest margin increased from 3.72% in the fourth quarter of 2025 to 3.96% in the first quarter of 2026. This 24 basis point increase in net interest margin is one example of the positive impact from the merger. The company anticipates improved profitability following the systems conversion and consolidation of operations this fall, which will also lower our expenses.

Brian, I'll turn the call back to you for any closing comments.

Thanks, Bryan. I'd like to thank Bryan McDonald, the management team and the entire organization for their leadership this past year. I'm pleased to be the Board Chair and have complete confidence in the team to continue to lead the company and Heritage Bank through this phase of our growth.

That concludes our agenda. And with no further business to come before this meeting, I declare the meeting adjourned. Thank you again for your continued support of Heritage Financial Corporation.

This concludes the meeting. You may now disconnect.

Thank you for standing by. My name is Angela, and I will be your conference operator today. At this time, I would like to welcome everyone to the Heritage Financial 2026 Q1 Earnings Call. [Operator Instructions]

I would now like to turn the call over to Mr. Bryan McDonald, President and CEO. You may begin.

Thank you, Angela. Welcome and good morning to everyone who called in and those who may listen later. This is Bryan McDonald, CEO of Heritage Financial. Attended with me are Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer.

Our first quarter earnings release went out this morning premarket, and hopefully, you have had the opportunity to review it prior to the call. In addition to the earnings release, we have also posted an updated first quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity and credit quality. We will reference this presentation during the call.

As a reminder, during this call, we may make forward-looking statements, which are subject to economic and other factors. Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within the earnings release and the investor presentation.

We closed the merger with Olympic Bancorp during the first quarter, better positioning our company for growth in Puget Sound market. I want to highlight a couple of items as we look forward. First, as a reminder, we are converting systems in late September, and we'll be carrying higher expenses until after the conversion. Don Hinson will provide additional color on our estimated expense levels post conversion of units.

Second, seeing the expected improvement to our net interest margin resulting from the addition of Olympics' balance sheet and continued asset repricing. We expect the upward trajectory to continue, primarily driven by new loans and repricing within the existing loan portfolio.

We will now move to Don, who will take a few minutes to cover our financial results.

Thank you, Bryan. I'll be reviewing some of the main drivers of our performance for Q1. As I walk through our financial results, unless otherwise noted, all the prior period comparisons will be with the fourth quarter of 2025. I will also be incorporating the impact of the Olympic merger into [indiscernible].

Starting with the balance sheet. Total loan balances increased $939 million in the first quarter. Loans acquired in Olympic totaled $954 million. Q1 yields on the loan portfolio were 5.73%, which was 19 basis points higher than Q4. The Olympic merger had a significant impact on the yield for the quarter as we brought over their loan portfolio at current market rates. In addition, approximately 6 basis points of the increase was due to the recovery of interest on nonaccrual loans. Bryan McDonald will have an update on loan production rates in a few minutes.

Total deposits increased $1.33 billion in Q1. Deposits acquired in the Olympic merger totaled $1.39 billion. The decrease in deposits ex the acquired deposits was partially due to the maturity of $29 million of brokered CDs that were not renewed. The cost of interest-bearing deposits decreased to 1.71% from 1.83% in the prior quarter. This decrease was due partly to the merger as Olympic had a lower cost deposits and partly as a result of the Fed rate cuts in Q4, which resulted in lower deposit rates.

Investment balances increased $388 million from the prior quarter, also due to the Olympic merger. Although we have reported that only $312 million was acquired in the merger, a portion of Olympic's investment portfolio as part of our restructuring strategy was sold prior to the merger date and reinvested subsequent to the merger.

The yield on the investment portfolio increased 17 basis points due to acquiring the portfolio at current market rates.

Moving on to the income statement. Most categories increased from the prior quarter due to the merger. I will cover a few areas of note. In addition to the impact of the earning assets acquired in the merger, net interest income also benefited from an increase in the net interest margin. The net interest margin increased to [ 3.96% ] and from 3.72% in the prior quarter and from 3.44% in the first quarter of 2025. The increase was due primarily to the previously mentioned increases in yields on the loan and investment portfolios and a decrease in the cost of deposits.

The previously mentioned recovery of interest on nonaccrual loans had a 5 basis point impact on the margin for the quarter. We recognized a reversal of provision for credit losses in the amount of $1.03 million in Q1. This reversal was due primarily to adjusting the allowance from 1.10% at the end of 2025 to 1.06% at the end of Q1. This decrease in allowance was due to the acquired Olympic loan portfolio, requiring a lesser allowance based on the specific attributes of that portfolio. In addition, net charge-offs remain at very low levels. Tony will have an additional information on credit quality metrics in a few moments.

In addition to the scale of a larger organization, the increase in the noninterest expense was also due to merger-related costs of $5.2 million versus $385,000 in the prior quarter and intangible amortization expense of $2.1 million to $285,000 in the prior quarter.

Due to the fact that the systems conversion for Olympic is scheduled for late Q3 of this year, we expect elevated expense levels until Q4. Based on the current forecast of staffing levels and merger-related costs, including the fact that Q1 only included 2 months of combined operations with Olympic, we are expecting quarterly noninterest expense levels to increase to an average of approximately $64 million to $65 million in Q2 and Q3 before decreasing to a range of $56 million to $57 million in Q4.

And finally, moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds, and our TCE ratio was 9.6% at the end of Q1 compared to [ 10.1% ] in the prior quarter. The decrease in the TCE ratio was expected due to the impact of the merger.

I will now pass the call to Tony, who will have an update on our credit quality.

Thank you, Don. I'm pleased to report that credit quality remained strong and stable in the first quarter. With the addition of the Olympic portfolio during the quarter, the high quality of these loans had a positive impact on our credit metrics at quarter end.

Nonaccrual loans totaled $15 million at quarter end, declining by $6 million during the quarter. This represents 0.26% of total loans and compares to 0.44% at the end of 2025. Most of the improvement came from the full repayment of $5.8 million residential construction loan and a $1.5 million multifamily term loan. Partially offsetting the improvement was the movement of a $2.6 million [indiscernible] to nonaccrual status. Within our nonaccrual loan portfolio, we have just under [ $4.2 ] million in government guarantees. Notably, there were no nonaccrual loans in the acquired Olympic portfolio at quarter end.

With the decrease in natural loans, the ratio of nonperforming loans to total loans improved to 0.26% from 0.44% at the end of 2025. During the quarter, we acquired an ORE property through a foreclosure action. This is a single-family residence with a book balance of $755,000. The house will be marketed for sale in the second quarter. This is the first ORE property we've held since 2020.

Criticized loans, those rated special mention or worse, moved higher during the quarter by $37 million with $18 million coming from the inclusion of the Olympic portfolio. As a percentage of total loans, criticized loans were stable at 3.9%, the same percentage that we experienced at the end of 2025.

When looking at the severe substandard category, we saw an improving trend during the quarter. Substandard loans to total loans dropped to 2.1% at quarter end versus 2.4% and at the end of 2025. Most of the improvement was from the [indiscernible] of the 2 nonaccrual loan relationships mentioned previously. It should also be noted that the Olympic portfolio had lower levels of criticized loans relative to their total loans, which had a positive impact on the combined ratios.

Page 18 in our investor presentation shows the stability in our criticized loans over the past 4 years.

As of quarter end, our ratio of total nonowner-occupied CRE loans to total loans moved just above the regulatory guidance level to [ 301% ]. The increase in the ratio was due to the inclusion in the Olympic portfolio and the fair value accounting for the acquisition. While growth in CRE loans was modest during the quarter, the lower combined capital level from the fair value marks resulted in a higher total CRE ratio. The increase was expected from our acquisition model, and we anticipate the ratio will decline to historical levels over time.

During the quarter, we experienced total charge-offs of $583,000. Approximately 70% came from our commercial portfolio, with the remainder coming from our consumer loans. The losses were partially offset by $31,000 in recoveries, leading to net charge-offs of $552,000 for the quarter. On an annualized basis, this represents 0.04% of total loans and is consistent with the 0.03% ratio that we achieved for the full year 2025.

While we are pleased with the stability in our credit metrics through the first quarter, we are aware of the emerging risks in the economy and the potential impact on our credit quality. We remain consistent in our disciplined approach to credit underwriting and believe this is reflected in the strong credit performance we have maintained over a wide range of business cycles.

I'll now turn the call over to Bryan for an update on our production.

Thanks, Tony. I'm going to provide details on our first quarter production results, starting with our commercial lending group. For the quarter, our commercial team closed $166 million in new loan commitments, down from $254 million last quarter and down slightly from $183 million closed in the first quarter of 2025. Please refer to Page 12 in the investor presentation for additional detail on new originated loans over the past 5 quarters.

The commercial loan pipeline ended the first quarter at $631 million, up from $468 million last quarter and up from $460 million at the end of the first quarter of 2025. Loan balances increased $939 million during the quarter. Majority of this increase was due to the merger, but Heritage loan balances, excluding any impact from Olympic, were up $20 million in the quarter. Based on the current pipeline, we expect an annualized loan growth rate in the mid-single-digit range in the next couple of quarters.

Deposits increased just over $1.3 billion due to the merger. Excluding the merger, deposits decreased $61 million, which included a $29 million decline in brokered CDs. The first quarter decline is typical of our deposit seasonality, with declines often occurring in the first quarter and through the end of April due to tax payments. The deposit pipeline ended the quarter at $81 million compared to $108 million in the fourth quarter, and average balances on new deposit accounts opened during the quarter are estimated at $33 million compared with [ $45 million ] last quarter.

Moving to interest rates. Our average first quarter interest rate for new commercial loans was 6.11%, which is down 45 basis points from the 6.56% average for last quarter. This rate average is based on outstanding balances. Using average commitment balances, the average was 6.41%. In addition, the first quarter rate for all new loans was 6.16%, down 27 basis points from 6.43% last quarter.

In closing, as mentioned earlier, we are pleased to have the Olympic merger closed, which strengthens our position in the Puget Sound. And overall, we believe we are well positioned to navigate what is ahead and to take advantage of various opportunities to continue to grow the bank.

With that said, Angela, we can now open the line for questions from call attendees.

[Operator Instructions] Your first question comes from the line of Jeff Rulis with D.A. Davidson.

I wanted to circle back on the expenses. I wanted to -- it seems kind of high. I understand that you've got Olympic for the full quarter, but, by chance, are you including additional merger costs in that 60% -- I think you said 64% to 65% in the next couple of quarters?

Jeff, yes, yes, that includes the merger-related expenses. If you take out merger costs, we're more in the $57 million to $58 million range for the next 2 quarters and then dropping to about $55 million by Q4. So that -- I was not putting everything in that.

So $55 million post-deal ex merger is the run rate that you're pointing to in Q4?

Yes.

Okay. And if you could -- Don, the you offered some rough detail on where those merger costs were by line item, but do you have a dollar figure just to kind of really carve those out, if possible?

Like over the remaining 3 quarters? Or -- is that what you're looking for?

No, no, no. In the trailing quarter, the 1Q to -- just over $5 million. The book, if you could just point as to where that -- by line item, that was mapped?

Well, professional services would be a big one on that. And then also the compensation because of severance would be some. And then we -- I think we also have some contract stuff that would show up in potential data processing. But those are the bigger ones. I don't have it broken out by type, that $5 million.

Okay. That's helpful. We'll just kind of give up that. Great. And then on the margin, did you say it was the interest recovery was 5 or 6 basis points beneficial to the margin?

To the margin? It was -- for the quarter, I think, it was[ 5 ] in the quarter. For the interest reversals? .

Yes.

Yes. On the interest reversal, it was [ 5 ]

Okay. And moving..

[ 6 ] on the lower.

Okay, [ 6 ] on the loan yield. [ 5 ] the margin. I appreciate it. And then I guess Don, do you have the margin average for the margin, maybe .

I've got that. Yes. I knew you ask for. So I know somebody would ask for it. the margin -- if I take out the interest reversals for March NIM, it was 395%. But if we take out the interest reversals that we had because a lot of them have happened in March, it was 395%.

Okay. And the 395% will include accretion that's part 1 and then part 2? Okay. And then I guess your -- is there any kind of heavy handed accretion upfront? Or could we kind of .

Yes. I mean there's always a chance that you're going to get a large payoff that will cause it to increase, but I don't expect to be anything unusual we've been experiencing so far. And of course, we've had 2 months of experience. But I don't think it's going to be -- I think anything happened in March that was unusual compared to the rest of the going forward.

And then leaning back to the introductory comments about upward trajectory from here. We'll kind of do what we will with accretion, but the core sounds fairly positive. Any sort of further comments on how you have a 4% plus or -- anything on the forward margin expectations with that upward trajectory in mind?

Yes. I think we're going to continue to see margin expansion not going to be significant, but again, depending on things like how much we can leverage the balance sheet and the loan growth we'll get a little bit of increase every quarter due to the fact that, again, the loans are repricing every quarter. So the ones that are either adjustable or are the new ones coming on are higher, I expect to reach the 4% by the end of the year or before.

Your next question comes from the line of Jackson Laurent with Stephens.

This is Jackson on for [ Andrew Terrell ]. If I could just start off on the balance sheet. I appreciate the color on the updated growth trajectory for loans. I was just wondering where you guys are seeing signs of strength in the portfolio? What you guys are seeing from the Kitsap bankers early on? And then maybe just a little bit of color on what caused the change in expectations. I think we were talking about upper single digits in January after kind of low single digits in the first quarter?

Sure. Maybe I'll go to Tony Chalfant first, just for comments just on credit in general, and then I'll pick up on the Kitsap commercial bankers and loan pipeline and outlook.

Yes. Thanks, Bryan. This is Tony. Yes, Jackson, with the merger, the credit crises were pretty similar. So we haven't really had to make any real changes in our approach with the Kitsap bankers, they're -- they look at credit very similarly to how we look at it. I think there's going to be some opportunities for some of their better borrowers to have some higher borrowing limits, which will probably help extend those relationships a bit more.

But generally, we're feeling pretty comfortable on a go-forward basis on a combined basis. Areas of strength really continue to be just a lot of opportunities in the owner-occupied CRE space and continuing to really push as hard as we can on the C&I space just because it comes with the relationship and deposits and such.

Bryan, I'll let you kind of cover the pipeline things.

Yes. Really, the primary driver behind the change in loan growth from last year was the larger level of construction loan costs that we had in 2025, which we mostly work through before the end of the year. Those were the larger ones that we had been expecting, and that was really related to just a bulge in construction loan activity in prior years that then converted to payoffs last year.

We did have a few payoffs in the Kitsap portfolio that were not unexpected, but a few larger ones than that transpired before and after close. The driver behind the go-forward growth rate is really the change in the pipeline. It was the pipeline had been growing when we did our Q4 all in January, and we've seen it continue to grow. The pipeline is up 35% over where it was at the end of Q4 and up a little more than that when you compare it to Q1 a year ago.

And we did see some of the deal closings push a little bit from first quarter, expect them to close in the second quarter. So we didn't close quite much as we anticipated we might when we were on the Q4 call. But regardless, we're still seeing a good pipeline and absent some change in borrower behavior related to outside factors. We feel good about that pipeline driving kind of mid-single-digit loan growth in the next couple of quarters.

Got it. That's all super helpful. And then maybe just switching to deposit costs. I mean, we've all heard a lot on competition recently. And we personally would track CD promotional rates, and it looks like you guys raised your highest rate recently. So just kind of given your already low cost of deposits, I was just wondering how you guys are thinking about deposit repricing going forward. And if you guys think there's any risk to upward migration in deposit costs throughout this year?

Don, do you want to start and I'll add some comments after you're done.

Sure. Yes, the competition is out there. We did raise our very highest rate, some on the CD side. While we're talking about cost deposits for the quarter, it's [ 171 ] or -- for March, it was [ 168 ]. So it came down a little bit. But I really don't expect it to move a whole lot. Now I think we'll get a little bit of help from some higher CDs coming down and -- but I think there will also be upsets to potentially if you're bringing in some maybe new customers or new -- with full relationships, there could be high rates you're paying there. So I think it's going to offset, and I think we're to stay right around that were [ 168 ] now again for the -- for March, I think we'll stay right around that for the remainder of the year, hovering around [ 170 ]. It's not going to move much, I don't think, at this point, [indiscernible] does something .

And [indiscernible] I would just add, you're right. As Don confirmed, we are seeing stronger deposit competition out there for kind of any excess dollars going into money market accounts or CDs. We're having good success with our relationship strategy, which is really the way that we're driving our deposit growth. So we are having to continue to compete for those kind of those extra funds, if you will, but still winning good quality operating relationships, and that's what's allowing us to keep the overall mix in alignment with where it's been before. and the cost at these levels?

Got it. That's helpful. And then maybe just lastly, switching over to capital. I know you guys focus is probably still on for integration and the conversion in 3Q, but just wanted to get your updated thoughts on the buyback and maybe potential future loss trades going forward?

Sure. We don't -- at this point, any loss trades, things things can change on that, but we will be always looking to manage capital to keep it. I think we're in a pretty good range right now where it's at. So we may be doing things such as being involved in buybacks to kind of manage our capital levels. We still have about 800,000 shares left in our current repurchase plan. And so we may be active this quarter in that.

Your next question comes from the line of [indiscernible] with KBW.

This is Charlie on for Kelly Motta. Just wondering with the ongoing disruption across Pacific Northwest banks and think that your employee count jumped with the addition of Kitsap here. Are you seeing opportunities to recruit any commercial banking teams or individual producers beyond Kitsap app? Is there any incremental like hiring embedded in expense run rate 2026?

We are out recruiting. We would traditionally add high-quality bankers as they be available across the footprint. We're not seeing necessarily an increase in total banker head count just because we continue to have retirements of our long-time makers. But we have been adding bankers in a number of our teams, just 1 or 2 to a particular team but those have been largely netted out so far with retirements.

We are continuing to talk to folks, certainly would be open to doing teams if the right opportunities came our way like we have in the past. But so far, it's been on to spread out amongst various teams.

Great. And then I guess just on a step down on the acquisition, understanding conversions in 3Q. Just wondering like where if anywhere execution has kind of run, ahead of or behind schedule, just kind of maybe stepping back on? Customer retention, producer retention, any like synergy realizations, just how things are holding up that integration?

Yes. I would say we're right on track. Obviously, there's many components to the integration plan. But we look at those status every week and right on track. I think from a customer impact standpoint, it's been really -- there hasn't been any kind of negative customer response to the combination. But I think we'll learn more on that when we actually go through the systems conversion.

But of course, we've retained all the branch teams, the commercial bankers. And so for the customers, they haven't had any sort of disruption as Tony Chalfant mentioned, a good fit between credit culture, so no disruptions there. So overall, going as we had hoped and anticipated.

Your next question comes from the line of [indiscernible] with Raymond James.

This is Evan on for David Feaster. Just sticking on loan growth. I just was kind of curious. The color on the pipeline was really helpful. But maybe more broadly, I'm curious how borrower sentiment has been holding up within your markets, especially with some of the macro insertion we've been experiencing.

And then maybe a follow-up to that, just like on payoffs and pay downs. I know they've been a headwind to the industry broadly. Good to see those pressures abating this quarter. So I'm kind of expecting what you expect to see on payoffs and paydowns going forward as well?

Sure. We've really seen the pipeline build since last summer after the big beautiful bill passed just incrementally. And we did see some delay in deals closing, but -- and that's part of the growth in the pipeline, maybe a little bit lower closings in Q1 than what we potentially could have had. But overall, continuing to see good growth in the pipeline after the increase in disruption related to the war.

So we're watching it really closely. Typically, when you have disruption, there's some of the customers that just decide to hold for a little while or delay. We're not seeing that so far. But it may be a little early to tell what the final implications will be in terms of how many deals fall out of the pipeline. But as we got to the tail end of the quarter and even coming into April, we've continued to see strong new deal flow into the pipeline.

And then on your second part of the question, just on payoffs and prepaid. Slide 15 in the deck has detail on last year and then Q1 of '26. And if you look at the prepayments and payoffs, last year, dividing that number by 4 to get a quarterly number, it's -- we're running a little lower in Q1 than we did on average last year, although we've got a much larger portfolio with the addition of the Kitsap and some of the payoff activity in Q1 was a couple of chunky deals on the Kitsap side.

So overall, that payoff activity is lower than what we encountered last year. We'll obviously continue to update everybody on that as we go quarter-to-quarter and get a better sense of if there's some chunkier deals in Kitsap portfolio that are going to going to pay off as we continue through the year. But now it's looking like that trend is going to be something lower than last year on prepays and payouts.

That's really helpful. And then maybe switching to credit. Credit trends were really good during the quarter. Non-accruals and standards were down. And it sounds like Kitsap is additive to your credit profile. But I'm just curious if you're seeing any specific sectors or business lines that are exhibiting maybe some outsized pressure or you're watching a little bit more closely than others?

Sure. Tony, you want to take that on?

Yes. Yes, Evan. I think we've seen over the last year the nonowner-occupied loan space has been really strong, really, really a solid part of our portfolio. Where we have seen a little more pressures, in the C&I portfolio. If you look year-over-year, we've had a bit of an increase proportionately in our special mention and substantial loans in the C&I category.

And a lot of that -- it's not really tied to none specific industry or one specific situation, but it all ties back to just the uncertainty in the economy. I mean, whether it's tariff issues, higher labor costs, supply chain issues, all of the above. And as you find in those kind of situations, companies -- some companies are just better positioned with management and balance sheet strength with [indiscernible] at than others. So we've just seen some weakness in that area as we go forward.

So here, we'll be watching closely, but it's really difficult to sort of pinpoint it to one specific industry or one specific issue. And it's -- but it's probably worth noting.

Does that cover your question, Evan, do you have more -- you want me to hit on?

That concludes our question-and-answer session. I will now turn the conference back over to Mr. Bryan McDonald for closing remarks.

Thank you, Angela. If there are no more questions, then we'll wrap up this quarter's earnings call. We thank you for your time, your support and your interest in our ongoing performance. We look forward to talking with many of you in the coming weeks. Have a good day.

Ladies and gentlemen, that concludes today's call. Thank you all for joining. You may now disconnect.

Hello, everyone, and welcome to the Heritage Financial 2025 Q4 Earnings Call. My name is Emily, and I'll be coordinating your call today. [Operator Instructions]

I would now like to turn the call over to Bryan McDonald, President and CEO, to begin. Please go ahead.

Thank you, Emily. Welcome, and good morning to everyone who called in and those who may listen later. This is Bryan McDonald, CEO of Heritage Financial. Attending with me are Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer.

Our fourth quarter earnings release went out this morning premarket, and hopefully, you've had the opportunity to review it prior to the call. In addition to the earnings release, we also posted an updated fourth quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity and credit quality. We will reference this presentation during the call.

As a reminder, during this call, we may make forward-looking statements, which are subject to economic and other factors. Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within the earnings release and the investor presentation.

Our improving net interest margin and a shift in our loan mix benefiting the provision expense drove earnings higher in the fourth quarter. On an adjusted basis, diluted earnings per share was up 18% versus last quarter and up 29% versus the fourth quarter of 2024. And on the same adjusted basis, our ROA improved to 1.29% versus 0.99% in the fourth quarter of 2024.

We now have regulatory and shareholder approval for the pending merger with Olympic Bancorp and plan to close at the end of January. Their addition to the Heritage franchise will add to the profitability of our operations and better position our company for growth in the Puget Sound market.

We will now move to Don, who will take a few minutes to cover our financial results.

Thank you, Bryan. I will be reviewing some of the main drivers of our performance for Q4 as I walk through our financial results, unless otherwise noted, all the prior period comparisons will be with the third quarter of 2025.

Starting with the balance sheet. Total loan balances increased $14 million in Q4. Yields on the loan portfolio were 5.54%, which is 1 basis point higher than Q3. The positive impact of new loans being originated at higher rates and adjustable rate loans repricing higher was partially offset by the impact of 3 rate cuts over the last 4 months of the year. Bryan McDonald will have an update on loan production and yields in a few minutes.

Total deposits increased to $63 million in Q4. This increase was due primarily to a $100 million increase in interest-bearing demand deposits. The cost of interest-bearing demand deposits decreased to 1.83% from 1.89% in the prior quarter. As a result of rate cuts in Q4, we expect to see continued decreases in the cost of deposits.

Investment balances decreased $31 million due primarily to expected principal cash flows on the portfolio. The yield on the investment portfolio decreased 9 basis points to 3.26% for Q4 compared to 3.35% in Q3. This decrease was partially due to a bond called in Q3 that provided approximately 4 basis points of additional accretion income that quarter and partially due to the runoff of higher-yielding bonds without replacement of those balances at current market rates.

The cash flows provided by the investment portfolio as well as growth in deposits was used to pay down borrowings during the quarter. Borrowing balances decreased to $20 million at year-end from $138 million at the end of Q3. The remaining balances all mature in 2026.

Moving on to the income statement. Net interest income increased $1 million or 1.7% from the prior quarter due primarily to a higher net interest margin. The net interest margin increased to 3.72% from 3.64% in the prior quarter and from 3.36% in the fourth quarter of 2024. We recognized a reversal of provision for credit losses in the amount of $814,000 in Q4. This reversal was due primarily to a change in the mix of the loan portfolio.

During Q4, commercial construction loans decreased while permanent commercial real estate loan balances increased. We consider construction loans to have an inherently higher credit risk component and provided a much higher allowance on those loans. Therefore, the reallocation of those balances resulted in the allowance decreased to 1.10% in Q4 from 1.13% in Q3. In addition, net charge-offs remain at very low levels. Tony will have additional information on credit quality metrics in a few moments.

Noninterest expense decreased $132,000 from the prior quarter due mostly to lower merger-related expenses. Comp and benefits expense was higher due primarily to increased incentive compensation accrual and not due to additional employees. We continue to manage our employee levels carefully as shown by decreases in average FTE from both the prior quarter and the same quarter in the prior year.

And finally, moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds and our TCE ratio was 10.1%, up from 9.8% in the prior quarter. We were inactive in both lost trades on investment and stock buybacks in Q4.

I will now pass the call over to Tony, who will have an update on our credit quality.

Thank you, Don. I'm pleased to report that we ended the year with strong credit quality across all segments of our loan portfolio. Nonaccrual loans totaled $21 million at year-end, and we do not hold any OREO. This represents 0.44% of total loans and compares to 0.37% at the end of the third quarter. The increase was primarily attributed to 3 nonowner-occupied CRE loans that were moved to nonaccrual status due to their delinquency. These loans are all well secured and are expected to pay off from either sale or refinance of the underlying properties with no anticipated loss.

Total nonaccrual additions of $4.4 million were partially offset by $1.1 million in payoffs or paydowns. Within our nonaccrual loan portfolio, we have just over $2.4 million in government guarantees. Nonperforming loans were stable during the quarter with the 0.44% of total loans matching the ratio at the end of the third quarter. In addition to nonaccrual loans, loans over 90 days and still accruing was limited to one small residential mortgage loan with a balance of $194,000.

Criticized loans moved lower during the quarter. However, we did see an increase in our substandard loans. Criticized loans totaled just under $188 million at year-end, declining by $6.6 million during the quarter. While special mention loans were lower by 29%, some were downgraded to substandard, resulting in a 24% increase in that risk category during the quarter. The largest contributor to the increase came from the downgrade of 2 C&I relationships totaling just under $30 million.

Partially offsetting the downgrades was the resolution of a long-term problem loan workout for a nonowner-occupied CRE loan, resulting in a full payoff of $15.6 million. While we are closely watching this increase in substandard loans, they remain at manageable levels at 2.44% of total loans and in line with our longer-term historical performance. Page 19 in our investor presentation provides more detail on the composition of our criticized loans and reflects the stability we've seen over the past 2 years.

During the quarter, we experienced total charge-offs of $640,000, primarily in our commercial loan portfolio. The losses were partially offset by $159,000 in recoveries, leading to net charge-offs of $481,000 for the quarter. For the full year, total net charge-offs were just under $1.4 million or 0.03% of total loans. This compares favorably to our 2024 performance, where net charge-offs were just over $2.5 million, representing 0.06% of total loans.

We are pleased that our early identification and proactive management of problem credit has led to another year of exceptionally low loan losses. The correlation between these credit management practices and our low level of historical loan losses is demonstrated on Page 20 in the investor presentation. Overall, we remain pleased with the credit quality of our loan portfolio at year-end. We believe our consistent and disciplined approach to credit underwriting and concentration management will continue to generate strong credit quality performance in a wide range of economic conditions.

I'll now turn the call over to Bryan for an update on our production.

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 $254 million in new loan commitments, down from $317 million last quarter and down from $316 million closed in the fourth quarter of 2024. Please refer to Page 13 in the investor presentation for additional detail on new originated loans over the past 5 quarters.

The commercial loan pipeline ended the fourth quarter at $468 million, down from $511 million last quarter and up modestly from $452 million at the end of the fourth quarter of 2024. As anticipated, loan balances were fairly flat quarter-over-quarter with a $14 million increase in the quarter. Total new loan production of $271 million was largely offset with elevated payoffs and prepaids. Looking year-over-year, prepayments and payoffs were $208 million higher than the prior year and net advances on loans have swung from a positive $153 million last year to a negative $81 million in 2025. Please see Slides 13 and 16 in the investor presentation for further detail on the change in loans during the quarter.

Looking ahead to 2026, we expect to resume loan growth at more historical levels as we are through the period of [ known ] elevated loan payoffs, and we expect net advances to move back to a positive position. Deposits increased $63 million during the quarter and were up $236 million for the year. The deposit pipeline ended the quarter at $108 million compared to $149 million in the third quarter, and average balances on new deposit accounts opened during the quarter are estimated at $43 million compared to $40 million in the third quarter.

Moving to interest rates. Our average fourth quarter interest rate for new commercial loans was 6.56%, which is down 11 basis points from the 6.67% average for last quarter. In addition, the fourth quarter rate for all new loans was 6.43%, down 28 basis points from 6.71% last quarter.

In closing, as mentioned earlier, we are pleased with our solid performance in the fourth quarter. Our assets continue to reprice upward and deposit growth has allowed us to pay down borrowings. These factors drove our net interest income up $1 million versus last quarter and up $4.6 million versus the fourth quarter of 2024. The combination with Olympic Bancorp and its subsidiary, Kitsap Bank, will add to this positive momentum. We look forward to having the exceptional bankers at Kitsap join the Heritage Bank family and are excited about what we can accomplish together. Overall, we believe we are well positioned to navigate what is ahead and to take advantage of various opportunities to continue to grow the bank.

With that said, Emily, we can now open the line for questions from call attendees.

[Operator Instructions] Our first question today comes from Jeff Rulis with D.A. Davidson.

Appreciate that Slide 28. The Slide 28, I think, outlined a pretty good outlook for your adjustable rate opportunity. It looks like within the next year, almost a 200 basis point potential there if repriced. I mean maybe, Don, if you could kind of unpack the margin outlook given it looks like you got some earning asset reprice opportunities still to come?

Yes. Thanks, Jeff. There's -- if we look back and see what happened, we -- this last quarter, we had -- well, we've had about 3 rate cuts in the last 4 months of the year. And we were still able to slightly grow our loan yields in Q4. So this is where the -- in a quarter where we have rate cuts, we're going to have this balancing where we're repricing our adjustable rate loans higher, putting on new loans at higher rates, but the adjustable rate loans or the floating rate loan will be obviously repriced down those tied to [ prime ] or SOFR. So kind of even for this last quarter, if we have quarters where we don't have rate cuts, we expect more improved improvement in the loan yields.

And then on the deposit side, the cuts help us speed up, I guess, our deposit betas. But at the same time, I think because we had rate cuts at the end of the year, I think we'll continue to see some improvement in our -- on the cost. So overall, I think that -- and this is all without the merger, right, that's going to occur. So just on the -- on the legacy Heritage side, we expect to see margin improvement to continue over the next year or 2.

Got it. And if I could take that step of incorporating Olympic look like their margin was a little bit lower, but a smaller balance sheet and adding accretion. Any thoughts on the kind of the blended -- if we look at legacy upward trending roll in Olympic, any broad level thoughts on the consolidated margin?

Well, and I'm going to preface this if I get questions about this year as far as the combined because obviously, we have some fair value work to do once the deal closes, and we will get that done in this quarter. And so we've got some initial estimates from that we did in our due diligence. I don't think they've changed a whole lot, but I will just preface that, that it's a little less precise than we would might normally be on this. But there -- I think their loan portfolio will probably reprice with yields up in the low 6s. So if you think about that, and then the deposits are already -- I think they're over 20 basis points lower than our cost of deposits. And then the investment portfolio should reprice probably up into the low to mid-4s, which I think they're at 3 or a little under on there currently. So I think that we're going to get a nice bump in margin where we could potentially get near that 4% range by the end of the year.

Appreciate it, Don. And maybe if I hop over to -- well, Bryan, I appreciate the commentary on maybe getting back to normal on -- with payoffs maybe subsiding a bit. Is that historical rate kind of a mid- to high single digit? Is that what we could expect absent the balances from Olympic?

Yes, Jeff, it would just add to -- yes, so the short answer is yes, but would add to that, looking at the pipeline at the end of the fourth quarter, the $468 million, and we have good visibility near term. So I would say low single digits is our estimate kind of Q1. And then I would move that to upper single digits based on what we're seeing from the customer base and loan demand heading into 2026, which is the pipeline has been increasing since year-end. So that's our thought based on what we're seeing today.

Okay. So a slow rate and then accelerating as we go over the course of the year.

Yes.

Our next question comes from Matthew Clark with Piper Sandler.

This is Adam Kroll on for Matthew Clark. Yes. So Bryan, I think last quarter, you mentioned having a few chunky loans you expected to pay off in the fourth quarter. Just wanted to check if any of those got pushed to the first quarter? And just digging more into the loan growth guide in '26, what industries or geographies do you expect to drive that loan growth?

Yes. So the -- I would say the bulk of the payoffs we were anticipating did come through. The payoffs were -- payoffs and prepaids were a little over $170 million for the quarter, which was the highest quarter of the of the year. And so for the total year, it was more like $540 million, $550 million, around $45 million a month. We think that's going to moderate at least based on our current visibility, potentially 1/3 less.

And then as I said in my comments, last year, we had this -- last year being 2025, we had net advances on loans fall $81 million versus 2024, where they were up $153 million. So we've cycled through that. And I think we should also see net advances move up modestly in 2026. So potentially 1/3 less payoff prepay volume and then not the negative drag from net advances that we had in 2025. So that's kind of what's happened in '25, and it has played out substantially based on our expectations as we came into '25.

Got it. That's great to hear. And maybe switching to expenses. How are you thinking about operating expense growth, both on a legacy Heritage basis for '26? And just maybe what's a good starting point for pro forma 2Q expense run rate?

Sure. Don, do you want to take that?

Yes. I think we're combining with -- there's so much, I think, noise going on. I think maybe we'll just maybe just talk about what kind of we're expecting. We are expecting approximately $20 million, $21 million of merger-related expenses. So -- but we're moving those, I think starting in Q2. And the other thing we have going on here is our conversion is not expected to take place until sometime into September. So we're keeping a large amount of the employees that at some point will be gone by the end of the year, but we'll keep them through Q3 because it will be on 2 separate systems. Then we'll have a reduction of employees after that.

But probably a run rate for Q2 and Q3 will probably be in the 56s some -- probably somewhere in the 56% range, maybe a little 56%, 57%. So that will be for Q2, Q3, and then we'll have some -- we'll get more of our cost savings in Q4. And the core will probably be down more in the $54 million range after that.

Got it. And then just last one for me. I'd like to get your updated thoughts on crossing the $10 billion in asset threshold and just maybe what inning you're in, in terms of making the necessary investments to cross that $10 billion mark?

Bryan, do you want to take that one or?

Yes, sure. I'll take that one. Let me take the second part of your question first, just in terms of preparedness. We did extensive planning back in 2023 when we were about $7.7 billion in assets, felt like we had 3 or 4 years, but we wanted to be very clear on what we needed to do. So we put together a pretty detailed plan, met with our regulators and a variety of other parties. And so we've been making progress on that plan. Since then, with our deposit outflows we had in 2023, we felt like we had a little bit of additional time. And so anyway, we've been making progress on that and have a good view into what the requirements are.

In terms of when we cross the $10 billion, our focus now is on integrating Olympic and making sure that all aspects of that go as planned. On an organic basis, we're several years out from crossing the $10 billion. So that's how we're looking at it right now, executing on the plan to be ready, but still seeing ourselves a ways off from crossing it.

Our next question comes from Jackson Laurent with Stephens.

This is Jackson on for Andrew Terrell. If I could just start out on the margin, more specifically loan yields. You guys already touched on the fixed repricing benefits to loan yields a little bit earlier. I was just wondering if you could kind of give some color on what you're seeing on the competition front in your markets? It looked like origination yields stepped down a little bit quarter-over-quarter.

Yes. Sure, Jackson. I'll take that. So on commercial loans, the new loan production went on at 5.56% during the quarter. And then in total, it was 6.43%. So that was down a bit over -- a bit over Q3. Some of that's due to the drop in short-term rates, any variable rate loans we have just kind of naturally are going to come on at lower levels. And then the rest is just driven really off of what the Federal Home Loan Bank, particularly the 5-year index does during the quarter.

From just purely a competitive standpoint, it continues to be a really competitive market for the clients that we're going after and particularly so if it's a new relationship to the bank where there's maybe several banks competing for that opportunity, although I would say that's not significantly different than it normally is. So we're not seeing necessarily any outsized competition. It's just always competitive for that -- for the type of clients we're going after.

Got it. That's helpful. And then just on the deposit cost front, it sounded like maybe some positive carry forward into the first quarter. Just wondering, last quarter, you guys talked about around $1 billion of exception price deposits that were sitting around a 3% rate. Just wondering where that bucket is and where that is priced today? And also just how much room you guys have left on the deposit repricing front?

Don, do you want to take that?

Yes. We have -- we're still at about the same level of exception priced, but it's the cost -- overall cost at year-end, I think we're down to about -- I think we're at maybe [ $270 million ] at this point. So -- and we still have -- there's some other -- still other -- we still have about $100 million of floating rate public deposits that would come down if there were rate cuts. We didn't experience all that impact because, again, we had a rate cut in December. So we'll -- that will help out.

And of course, the CD rates, I think, keep coming down. So our average rate of CDs -- core CDs is like -- like [ 360 ], I think, we'll keep working those down. I think the current -- our current highest rate is like [ 330 ]. So there's definitely -- we're expecting costs to keep coming down. Our December cost was lower than for the quarter by about 4 basis points. So that's just, again, another sign that it's going to keep coming down a little bit.

Got it. That's helpful. And then just last one for me. I know we talked about like uses of capital being on hold until the closing of the Olympic transaction. But with a clear line of sight to deal close later this month and capital building nicely, I was just wondering if you could kind of update us on capital priorities in 2026?

Sure. Don, do you want to take that?

Sure. Well, again, the first one was just closing the transaction. And that will use about -- again, we've mentioned this before, about 100 basis points of capital. So that's the most important use of capital this year. We will look into other uses as we do more planning and as we get through, again, the fair value, so we really know what our balance sheet looks like, we can take, I guess, more steps to manage it to the levels that we want to be at. So there could be some buybacks. We have about 800,000 shares left in our current repurchase program. There's always a chance we could do more loss trades, but we're not planning any at this point. But there's a chance we could do. I would say we could do buybacks. If we find that the dilution is less, but maybe the accretion is less from the deal, then maybe buybacks make sense to kind of offset that. So we'll kind of -- we're working on that now. Again, after the deal closes at the end of the month, we'll definitely be looking carefully at that.

Our next question comes from Liam Coohill with Raymond James.

It's Liam on for David Feaster. So I wanted to touch on some of the impressive interest-bearing demand deposit growth you saw in the quarter. Could you maybe discuss some of the initiatives that you've been using to see success there? Is it mostly granular wins across the franchise?

Yes, Liam, it is. It's really a continuation of what we've been doing throughout the bank's history, just relationship banking, high service quality delivery. And then we added significantly to our deposit sales team over the last several years. And so we continue to see new relationships coming in from the investments we've made with our deposit teams. And Slide 11 in the investor deck has that detail. But back in 2022, we added 3 teams that year and 2/3 of that group were deposit-generating staff. And then, of course, several new locations, both in Oregon and then Boise and then also Spokane. So it is a continuation of what the banks always focused on, which is those relationship clients, but we've benefited pretty significantly from both the new teams as well as our existing efforts in that area.

Great. And just one more for me. On the credit side, I'm just curious if there's any underlying trends or industries that you're watching more closely? And on the couple of C&I downgrades in the quarter, were those idiosyncratic? Or were there any commonalities?

Sure. Tony, you want to take that one?

Yes, sure. Liam, there was really no correlation between those 2 deals. They're in kind of separate industries. And I guess the big question is -- was there any tie-in to tariffs or things like that? And I would say no. So not really anything that I can really point out to. Obviously, both being in C&I category jumps out, but I think it was just -- that was just more timing than anything else and doesn't really reflect anything that we're watching any more closely in the portfolio.

Our next question comes from Kelly Motta with KBW.

I guess as we look ahead, your efficiency ratio for the past couple of years has hovered in that mid-60 percentage range. You did a bunch of things with the securities loss trades and such expense saves in order to kind of mitigate some profitability headwinds. Now with the increased scale from Olympic, wondering how you're thinking about how that helps with generating perhaps better efficiency ahead? Is that a way you're thinking about it? Just interested in thoughts here since it seems like the growth and margin picture is shaping up quite nicely.

Yes. Maybe, Kelly, thanks for the question. I'll have Don start and then maybe I'll provide some comments after Don shares his thoughts.

Okay. Thanks, Bryan. Yes, we're going to -- I think just the overall -- are you talking about the efficiency ratio itself, Kelly? Or are you just talking about operations?

Yes. I was speaking specifically with the efficiency, but I don't know how you necessarily think about it. So if it's easier to talk about it, just is operational efficiency in general, that's okay, too.

Okay. Well, I'll just touch on the -- obviously, we're going to get overall efficiencies between the 2 organizations. Our efficiency ratio will continue to go down over time. But I will say also that I think it will be mostly driven on the revenue side as opposed to the expense side, but we are looking at, again, trying to keep our expense base at a good level.

But Bryan, I don't know if you want to talk any more about what you see in the overall efficiencies of the organization.

Yes, I would just add a little bit on to what Don said. If you look at the trajectory of Heritage kind of independent of the combination with Olympic, we've had a big increase in our margin year-over-year. So Q4 last year was 3.36% and 3.72% and Don had mentioned in terms of answering Jeff Rulis' question, we see potential to get that margin potentially up in the 4% range within the not-too-distant future. So that's the revenue driver. Beyond that, the combination with Olympic is bringing a significant amount of low-cost deposits.

There's a little bit of a recap on Slide 6 of the investor presentation on the merger with Olympic. And one of the bullet points highlights their cost of deposits at [ 102% ]. It doesn't note their loan-to-deposit ratio, but it's in the mid-60s and ours, of course, is just over 80%. So there's potential significant potential upside. It just some moderate additional leveraging in the loans over the next few years that will give us room to drive that efficiency ratio lower.

So those are my thoughts. Obviously, we'll be continuing to focus on ways that we can continue to scale the company without adding significant cost. We'll be continuing to focus on our expense run rates. But if you look at kind of what's happening on the loan repricing side and the asset repricing, the addition of the Kitsap balance sheet mark-to-market on the asset side, it's a pretty good outlook. And then, of course, if you add the additional leveraging, there's a lot of additional potential beyond that.

Got it. Maybe last question for me. I realize this is a little early to be asking this question. But with Olympic on board, I'm just wondering if there's been any updated M&A conversations knowing that you've been more recently active here?

Sure. We're really focused on making sure that we get the combination with Olympic successfully integrated, and that's definitely our -- in our #1 priority here in 2026. We -- at the same time, we have continued to be active in conversations just as we always do so that if another bank within our footprint makes the decision that they want to partner with somebody that we're a known party to them and hope to be considered if that was the case. So really no change from our past conversations. We're continuing to have them. The only nuance, which I' just added is we're very focused on making sure that we get Kitsap integrated over additional M&A.

Thank you. At this time, we have not received any further questions. And so I'll hand the call back over to Bryan for closing remarks.

Okay. If there are no more questions, then we'll wrap up this quarter's earnings call. We thank you for your time, your support and your interest in our ongoing performance, and we look forward to talking with many of you over the coming weeks. Goodbye.

Thank you all for joining us today. This concludes our call, and you may now disconnect your lines.

Hello, everyone, and a warm welcome to the Heritage Financial 2025 Q3 Earnings Call. My name is Emily, and I'll be moderating your call today. [Operator Instructions]. I would now like to turn the call over to Bryan McDonald, President and Chief Executive Officer, to begin. Please go ahead.

Thank you, Emily. Welcome and good morning to everyone who called in and those who may listen later. This is Bryan McDonald, CEO of Heritage Financial. Attending with me are Don Hinson, Chief Financial Officer; and Tony Chalfant, Chief Credit Officer.

Our third quarter earnings release went out this morning premarket, and hopefully, you have had the opportunity to review it prior to the call.

In addition to the earnings release, we have also posted an updated third quarter investor presentation on the Investor Relations portion of our corporate website, which includes more detail on our deposits, loan portfolio, liquidity and credit quality. We will reference this presentation during the call.

As a reminder, during this call, we may make forward-looking statements, which are subject to economic and other factors. Important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within the earnings release and the investor presentation.

Improving net interest margin and tight controls on noninterest expense growth continue to incrementally drive earnings higher in the third quarter.

On an adjusted basis, earnings per share was up 5.7% versus last quarter and up 24.4% versus the third quarter of 2024. And on the same adjusted basis, our ROAA improved to 1.11% versus 0.87% in the third quarter of 2024.

We are excited about the pending merger with Olympic Bancorp. Their addition to the Heritage franchise will add to the profitability of our operations and better position our company for growth in the Puget Sound market.

We'll now move to Don, who will take a few minutes to cover our financial results.

Thank you, Bryan. I will be reviewing some of the main drivers of our performance for Q3. As I walk through our financial results, unless otherwise noted, all of the prior period comparisons will be with the second quarter of 2025.

Starting with the balance sheet. Total loan balances were relatively flat in Q3, decreasing by $5.7 million. Although loan originations increased from Q2 levels, payoffs and prepayments also increased in Q3, while utilization rates decreased.

Yields in our loan portfolio were 5.53%, which was 3 basis points higher than Q2. This was due primarily to new loans being originated at higher rates and adjustable rate loans repricing higher. Bryan McDonald will have an update on loan production and yields in a few minutes.

Total deposits increased $73 million in Q3 and noninterest-bearing deposits increased $33.7 million. The increase in total deposits was net of a $31.4 million decrease in certificates of deposit accounts, most of which was the result of a decrease of $25 million in brokered CDs.

The cost of interest-bearing deposits decreased to 1.89% from 1.94% in the prior quarter. As a result of the rate cut in September, we expect to see continued decreases in the cost of deposits.

Investment balances decreased $33 million due primarily to expected principal cash flows on the portfolio. Due to the desire to preserve capital for the pending acquisition, we halted loss trade activity in Q3. We also did not purchase any securities in Q3.

Moving on to the income statement. Net interest income increased $2.4 million or 4.3% from the prior quarter due primarily to a higher net interest margin. The net interest margin increased to 3.64% from 3.51% in the prior quarter and from 3.30% in the third quarter of 2024. We recognized the provision for credit losses in the amount of $1.8 million, up from $956,000 in the prior quarter due primarily to an increase in the weighted average life of the loan -- construction loan portfolio.

New construction loans increased the average life of the portfolio as well as reduced portfolio utilization rates. Net charge-offs remain at very low levels. Tony will have additional information on credit quality metrics in a few moments.

Noninterest expense increased $530,000 from the prior quarter due mostly to increased comp and benefits expense as well as professional services. We recognized 535 -- sorry, $635,000 of merger-related expenses in Q3, most of which was included in the professional services category. Comp and benefits expense was higher, primarily due to increased incentive compensation accrual.

And finally, moving on to capital. All of our regulatory capital ratios remain comfortably above well-capitalized thresholds and our TCE ratio was 9.8%, up from 9.4% in the prior quarter. Similar to our inactivity and loss trades on investments, we were also inactive in stock buybacks in Q3 and are unlikely to resume stock buybacks this calendar year.

I will now pass the call to Tony, who will have an update on our credit quality.

Thank you, Don. Through the first 3 quarters of the year, I'm pleased to report that credit quality remains strong and stable. Nonaccrual loans totaled $17.6 million at quarter end, and we do not hold any OREO. This represents 0.37% of total loans and compares to 0.21% at the end of the second quarter. The largest addition during the quarter came from 2 loans totaling $6.7 million that are primarily secured by a townhome construction project. That project is nearly complete and the unit should be listed for sale before year-end. There is currently no loss expected on these loans and the nonaccrual decision was primarily tied to the delinquency status.

Also within our nonaccrual loan portfolio, we have just over $2.8 million in government guarantees. Nonperforming loans increased modestly from 0.39% of total loans at the end of the second quarter to the current level of 0.44%. This increase was primarily tied to the previously mentioned increase to nonaccrual loans.

Criticized loans moved lower during the quarter. These loans rated special mention or substandard totaled just under $194.5 million at quarter end, declining by just over $19 million during the quarter. Substandard and special mention loans were down by 5% and 12%, respectively, during the quarter from a combination of payoffs and upgrades.

At 2% of total loans, substandard loans remain at a manageable level and in line with our longer-term historical performance. Page 19 in our investor presentation provides more detail on the composition of our criticized loans and reflects the stability we've seen in this portfolio over the past 2 years.

During the quarter, we experienced total charge-offs of $374,000 that were split evenly between consumer and commercial loans. The losses were partially offset by $256,000 in recoveries leading to net charge-offs of $118,000 for the quarter. For the first 9 months of the year, net charge-offs remained low at $911,000. This represents 0.03% of total loans on an annualized basis and compares favorably to the 0.06% we reported for the full year 2024. Page 20 of the investor presentation shows our history of low credit losses and how we compare favorably to our peer group.

We are pleased with the strength and stability of our credit metrics for both the quarter and through the first 9 months of the year. While we are closely watching the increase in our nonperforming loans, it is important to note they remain at a low level when compared to our historical trends. While there has been some economic volatility this year, we have yet to see any material impact on our credit quality.

We remain confident that our consistent and disciplined approach to credit underwriting will serve us well should the economy show any material deterioration in the coming quarters.

I'll now turn the call over to Bryan for an update on our production.

Thanks, Tony. I'm going to provide detail on our third quarter production results, starting with our commercial lending group. For the quarter, our commercial teams closed $317 million in new loan commitments, up from $248 million last quarter and up from $253 million closed in the third quarter of 2024. Please refer to Page 13 in the investor presentation for additional detail on new originated loans over the past 5 quarters.

The commercial loan pipeline ended the third quarter at $511 million up from $473 million last quarter and up modestly from $491 million at the end of the third quarter of 2024.

As we look ahead to the fourth quarter, we are estimating new commercial team loan commitments of $320 million, which is very similar to Q3 levels.

As anticipated, loan balances were fairly flat quarter-over-quarter with a $6 million decline in the quarter. Although total loan production was up $81 million or 30% versus last quarter, we continue to see elevated payoffs and prepaids. And similar to last quarter, the mix of loans closed during the quarter resulted in lower outstanding balances.

Looking year-over-year, prepayments and payoffs are $124 million higher than last year, and net advances on loans have swung from a positive $142 million last year, to a negative $75 million year-to-date in 2025. Please see Slides 14 and 16 of the investor presentation for further detail on the change in loans during the quarter.

Looking ahead to the fourth quarter, we expect loan balances to remain near Q3 levels then resume growth to more normal levels in 2026 as loan payoffs moderate, and the net advances moved back to a positive position. Deposits increased $73 million during the quarter and are up $173 million year-to-date. The deposit pipeline ended the quarter at $149 million compared to $132 million in the second quarter. And average balances on new accounts opened during the quarter are estimated at $40 million compared to $72 million in the second quarter.

Moving to interest rates. Our average third quarter interest rate for new commercial loans was 6.67%, which is up 12 basis points from the 6.55% average for last quarter. In addition, the third quarter rate for all new loans was 6.71%, up 13 basis points from 6.58% last quarter.

In closing, as mentioned earlier, we are pleased with our solid performance in the third quarter. Deposit growth has allowed us to pay down borrowings and broker deposits while our loans have continued to reprice upward. These factors drove our net interest income up $2.4 million versus last quarter and $4.4 million versus the third quarter of 2024. The combination with Olympic Bancorp and its subsidiary, Kitsap Bank, will add to this positive momentum in a significant way. We look forward to having the exceptional bankers of Kitsap join the Heritage Bank family and are excited about what we can accomplish together.

Overall, we believe we are well positioned to navigate what is ahead and to take advantage of various opportunities to continue to grow the bank.

With that said, Emily, we can now open the line for questions from call attendees.

[Operator Instructions]

Our first question today comes from Matthew Clark with Piper Sandler.

This is Adam Kroll on for Matthew Clark. Yes. So maybe just starting off on the margin. I was wondering if you had the spot cost of deposits at September 30 and maybe the NIM for the month of September?

Sure, Adam. Yes, spot rate on cost deposits was -- the interest-bearing was 1.87%. And that, of course, compared to 1.89% for the quarter and for total cost deposits of 1.35%. The NIM for September was 3.66% compared to 3.64% for the quarter.

Got it. That's super helpful. And then just on deposit costs. I guess how much opportunity do you still see to reduce rates on the nonmaturity side?

Well, we have close to -- I think where it comes into play is mostly close -- is approximately $1 billion we have in exception price as it's -- that are costing us currently close to 3%.

And so we will continue to, as rates are cut to work those down over time. It's a process, and it doesn't happen all at once. But we have been working them down some. I will say also, a lot of the new -- if we bring on new accounts, so they tend to be at the higher than the overall portfolio rate. So that mitigates some of the help of the rate cuts, but I do expect that we will continue to be able to work that down over time.

Got it. I appreciate the color there. And then maybe just one last one for me is I was wondering if you could just expand on how you're thinking about organic loan growth in '26? And do you have any visibility into payoffs and when they might normalize lower?

Sure, Adam. We're expecting to move back to more of our traditional range, mid- to high single digits next year. On the second quarter call, I had mentioned, anticipated growth hitting in the fourth quarter, and we have several additional larger payoffs we're now expecting here in the fourth quarter. So we're expecting to be flat again. So there's kind of 2 things going on.

One is the cycling of some construction loans we've booked over the last few years that are reaching perm and paying off. And you can see that on Page 14 in the investor presentation just with the utilization rates on the construction loans as those go to perm and pay off. And then we've -- a lot of the new bookings over the last couple of quarters have been in that construction bucket, and so our fundings have been lower.

If you look at the detail on the change in loans during the quarter, you can see our net advances on construction loans or actually on all of our lines is down this year versus up last year. So we expect, as we get into 2026, work our way through the rest of these payoffs that we'll have positive net advances on those loans, so a bit of a tailwind versus the headwind that we had this year.

And then the productions continue to be strong at over $300 million this last quarter and expecting, again, $300 million in Q4, over $300 million in Q4. It's a little harder for me to see out into 2026 because our pipeline is really accurate out 90 days. It's hard to anticipate loan demand in 2026, although I would say things have been strengthening since the summer. And so based on that, I'm not seeing anything at this point that would cause those -- cause loan demand to dip and the pipeline to shrink beyond all the obvious things that could drive that. We're just -- we're seeing the trend move in the other direction right now.

Our next question comes from Jeff Rulis with D.A. Davidson.

Maybe staying on the payoff front, just a follow-up. Any of that kind of managed by you or encouraged balance reductions for credit-related reasons?

Yes, Jeff, I would say the kind of the change in the fourth quarter is some several larger payoffs that are for adversely classified credits, not necessarily a circumstance where we're working them out of the bank, but ones where the customers have decided to sell the assets and pay it off. So that's the difference versus last quarter. We've got a few in that bucket and then one additional construction loan that's going to pay off in Q4. We're expecting Q4 versus previously we thought it push into '26. So that's the change for Q3. Not a huge number of loans, but a couple of chunky ones in there.

Sure. No, that's helpful. Just to kind of get the whole picture that on the edges, maybe some of that activity is positive. I wanted to talk about the deposit success in the quarter, a pretty good core deposit growth. Is that a bit of seasonal factors in play? Or is this just execution with the team, a bit of both? Just trying to see -- unpack that a little bit.

Yes, it is a bit of both. Third quarter, traditionally our strongest deposit growth quarter during the year, and that was the case last year, and we saw it this year, the years previously was hard to see it, of course, because of all the rate changes and the outflow of excess deposits. But yes, seasonal increase. And then we've had good additions from the new account activity side. And so those are driving the balances as well as some accumulation in customer accounts, again, more related to that seasonality.

Got you. And then connected maybe, Don, on the margin, I guess, it sounds as if that -- those deposit costs or spot rate and margin trending well. Is there a bit of a carryover or a declining benefit from the loss trades. I guess anything you give puts and takes on margin, particularly in light of cuts as well, rate cuts? Where would you sort of position the margin ahead?

Yes. I don't think we're going to get the margin growth based off the rate cut we had in mid-September, which we didn't feel the full effect of or experience full effect of and kind of expecting one next week. I think we're going to continue to get, again, help on the deposit side. But I think the loan yields are going to be fairly flattish this quarter. We're going to continue to be able to reprice adjustable rate loans higher and new loans going on will be higher. But those rate cuts when we have, I think, it's 22%, 23% fully floating that also impacts it.

So having a flattish loan yields for the quarter and maybe some help on the deposit side, I think we might continue to see some NIM improvement, but it will be muted compared to last quarter.

Our next question comes from Liam Coohill with Raymond James.

Liam On for David. So we've talked a lot about the deposit success in the quarter and I was curious, how has competition been trending in your markets, especially with a lot of banks targeting high levels of loan growth. Where are you seeing the most opportunity for gathering those deposits even in a seasonally stronger quarter?

Yes, Liam, really, it's same strategy we've deployed in the past going after the operating relationships, accounts that look for strong servicing. Don mentioned in his deposit comments that some of the new relationships we're bringing on have a little higher average cost than the bank's average. And that's because for those excess deposits to the extent that customers are shopping between a few banks, we're having to pay up on those excess deposits, maybe a little bit more so than we are within the portfolio on average.

But then, of course, we're getting strong demand balances along the way. So we still see competition in our market, strong pricing competition on deposits. It's kind of varied from local -- one local geography to another in terms of who the players are that are being particularly aggressive with deposits. So that continues to be a factor. But if you're going after the operating relationships, it's a different driver than price on that piece. So that's the key.

I appreciate that. And on the acquisition of Olympic, how has progress in the pending deal been trending? And what are the most pressing priorities from your view post deal approval and integration?

Yes, Liam, everything is progressing right as planned. We have a project plan and time line and everything is going smoothly. Not seeing anything at this point that, that would change kind of our estimated closing date beginning of Q1, we're on track for that. And then, of course, coordinating closely with the Olympic team to make sure everything goes smoothly and that's also been going very well. So nothing at this point of concern, just going just as we had anticipated.

Great. And then last one for me. I mean asset quality remains pretty strong broadly, and it's great to hear that, that credit migration is likely going to be resolved without loss in 4Q. With classified down quarter-over-quarter. Is there anything you're watching more closely moving forward? Or is all seemingly quiet?

Tony, I'll let you pick that one up.

Yes, Liam, it's a good question. I think what we're seeing is that the impact from some of the economic volatility has been sort of spotty through the portfolio, nothing really systemic. So we'll have -- we have a few loans that were relationships that we're looking at that have been impacted somewhat by that.

But generally speaking, it's just kind of the normal, ins and outs of -- into the classified criticized buckets that we typically see. So no real particular trends we're watching. And as Bryan mentioned, we do have some positive momentum in the substandard category that may play out in the fourth quarter or should play out in the fourth quarter. And that -- the loans that are in our nonperforming bucket right now, we're just not seeing a lot of material loss potential there as of right now.

Our next question comes from Jackson Laurent with Stephens.

This is Jackson on for Andrew Terrell. If I could just hit on expenses first, and I apologize if I missed it. Adjusting for like the merger costs in the quarter, expenses were right at the bottom end of like the previously guided $41 million to $42 million expense guide. Just wondering if that's a good run rate that we should be looking for going forward?

Sure, I'll take that, Bryan. The one impact to this quarter that we haven't had is the state raised their revenue tax rate and that's going to impact us by about $300,000 per quarter. So other than that, I expect it to be pretty similar. It fluctuates some, right? But still I would say in the low 41s core, and then we also have this $300,000 that we'll be dealing with. So it may pump up more into the mid-41s as a result. But that I think it still is a pretty good run rate overall.

And we'll still have some acquisition-related costs, which I'm not sure exactly when they're all going to hit. We're going to have some again this quarter, but there will also be some next quarter and of course, over the conversion post acquisition.

Got it. That's helpful. And then just last one for me. I know the primary focus has been on closing the current pending deal, integrating the franchise, but it seems like the M&A space has been heating up a little bit. Just wondering how you guys are thinking about M&A post deal close? And just honestly, how conversations have been trending recently?

Yes. Obviously, our first priority is to work through the transaction with Olympic and get that closed. We're anticipating early Q1 for the closure. We're continuing our discussions just like we always have. And if there was an opportunity that came up, we would consider it. So again, focuses on the Olympic deal and getting it closed.

But looking ahead to next year, if the right opportunity came along, we'd certainly be open to taking a look.

Our next question comes from Kelly Motta with KBW.

This is Charlie on for Kelly Motta. I guess just kind of piggyback on that last question. Just wondering how you're thinking about capital from here. You mentioned you're likely to pause the buybacks for the remainder of the year. once the Kitsap deal is closed and integrated successfully, do you expect capital priorities to change in any meaningful way going forward as a combined bank?

Don, do you want to comment on that one?

Sure. It's kind of hard to comment on this until we get through it and see exactly what -- where we're coming out, obviously, we modeled certain things but we'll probably hold -- we'll probably be preserving some capital as we're experiencing the transaction costs associated with it in addition to the upfront dilution.

So we do expect to be earning quite a bit of capital back over time. But it's kind of hard to comment if we're going to be involved in any sort of buybacks at this point. I really have a hard time commenting on that. We're just kind of wait and see.

I wouldn't plan on anything in your model at this point.

Understood. And then in terms of how you're thinking about the loan-to-deposit ratio, it came down a bit this quarter. And I know you expect some liquidity from the Olympic deal. Just wondering high level, how you're thinking about managing that ratio moving forward?

Yes. High level, we like to get it back up to 85% and we'd be comfortable a bit above that as well. So we're continuing to look for loan opportunities to deploy more of our assets into loans. So certainly, our goal is to move it up to 85% and certainly be comfortable a bit higher than that.

[Operator Instructions]

With that, we have not received any further questions. And so I will turn the call back over to Bryan McDonald for any closing comments.

Thanks, Emily. If there are no more questions, then we'll wrap up this quarter's earnings call. We thank you for your time, your support and your interest in our ongoing performance. We look forward to talking to many of you in the coming weeks. Goodbye.

Thank you, everyone, for joining us today. This concludes our call, and you may now disconnect your lines.

Good afternoon. My name is Elisa, and I will be your moderator for the conference call today. At this time, I would like to welcome everyone to the Heritage Financial Investor Call. [Operator Instructions] Thank you. Bryan McDonald, CEO of Heritage Financial, you may begin.

Thanks, Elisa. Good morning, everyone, and thank you for joining us. We are here to talk about the recently announced combination between Heritage and Olympic Bancorp, the parent of Kitsap Bank. During today's call, we will be referring to a presentation detailing the transaction, and I would encourage everyone to access this on our Investor Relations website. Attending with me are Don Hinson, Chief Financial Officer; Tony Chalfant, Chief Credit Officer; and Jennifer Nino, Chief Accounting Officer.

As a reminder, during this call, we may make forward-looking statements, which are subject to economic and other factors. You can find the investor presentation and press release on our corporate website and important factors that could cause our actual results to differ materially from those indicated in the forward-looking statements are disclosed within these documents. Yesterday, after the market closed, we announced an agreement to acquire Olympic Bancorp, the holding company of Kitsap Bank, a 117-year-old community bank headquartered in Port Orchard, Washington, with total assets of $1.7 billion. Kitsap is a high-quality community bank operating primarily in the Western Puget Sound region through 16 branches and 1 loan production office.

Kitsap's geographic locations, coupled with their operating model, make them a uniquely attractive merger target for us. The merger is a win-win for both sets of shareholders with material benefits from our added scale, deeper market presence and strong financial returns on a pro forma basis. The strategic fit of this merger is exceptional. Several key aspects of Kitsap's business demonstrate how well we are aligned with them. Both Kitsap and Heritage are centered on relationship banking, coupled with a strong commitment to community. Kitsap has operated for over 100 years and Heritage for nearly 100 years. When you execute a relationship banking strategy for a century, the result is typically demonstrated through loyal, low-cost core deposits. Kitsap's cost of total deposits is 1.09%, which is lower than Heritage's 1.40%.

Another feature of this longevity is a commitment to credit. A bank operating for 100 years has been through many cycles and survived and improved along the way. This is true for both Kitsap and Heritage. Both organizations have clean credit portfolios and a long track record of conservative underwriting. Kitsap's current NPA to assets ratio is 0.01%.

And finally, this is a great geographic fit. We will extend our footprint into adjacent communities in the western portion of Puget Sound, where we currently have no branch presence and Kitsap Bank has strong market share. There is overlap in 2 metro counties on the Interstate 5 corridor, enhancing our strong position in these markets. We are planning on retaining Kitsap Bank name at all branches, except for the offices overlapping with existing Heritage Bank offices in Pierce and King County.

Before I pass the call to Don, I want to share a bit about our past relationship with Kitsap Bank, its leadership and how this opportunity presented itself. For many years, our teams have often crossed paths at various banking association, advocacy and community events. And of course, we also compete for clients and banking talent. Over these many years, we, at Heritage, have developed a deep respect for Kitsap's leadership and employees and a strong admiration for their bank. So Kitsap has been on our radar for a while now, but as a 100-plus year-old privately held company, you just never know when or if an opportunity like this will surface. Let's just say we are very excited to put this transaction together and share this news with you today.

I'll now turn the call to Don Hinson, who will review the financials of the transaction.

Thank you, Bryan, and good morning, everyone. I will touch on the key financial terms of the merger as well as expected financial metrics. The merger is all stock with a fixed exchange ratio, whereby shareholders of Olympic Bancorp will receive 45 shares of Heritage common stock for each share of Olympic common stock. As a result, we will issue approximately 7.2 million shares of Heritage common stock. Based on our stock price of $24.64 as of the close of market this past Wednesday, September 24, the implied deal value is approximately $176.6 million. At this stock price, the price is 151% of Olympic's tangible book value or 103% if you exclude their AOCI. The value of the merger will fluctuate until closing based on the value of Heritage's stock price.

We expect closing to occur in Q1 2026, following which Olympic shareholders will own approximately 17.4% of the combined company. We believe that this is a well-priced transaction with attractive returns for our shareholders. The fully phased-in EPS pickup is projected to be approximately 18% in 2027. As always, we have been realistic and diligent in determining our modeling assumptions. We project the tangible book value dilution of under 10% at closing to be earned back in approximately 3 years using the crossover method. We are targeting 35% cost savings based on the identified efficiencies of combining our banks. Approximately 45% of these cost savings are expected to be realized in 2026, and we will have 100% realized in 2027 and beyond.

With our history of executing on strategic acquisitions, our teams have extensive experience in acquisition due diligence and integration. The Heritage team conducted thorough due diligence with experienced associates from across the bank participating in the effort. As part of the process, our credit review team performed a comprehensive review of Kitsap Bank's loan book. This included a detailed review of 53% of Kitsap's loans, including 88% of commercial loan commitments of $5 million or greater and 100% of criticized loans. Kitsap has a history of maintaining strong credit quality, and our teams found their approach to credit underwriting and monitoring to be sound.

Page 8 of the investor presentation discloses some of our key assumptions related to the modeling of the transaction. I want to point out that based on the new accounting guidance expected to be released in Q4 from FASB, we did not double count the loan credit marks as is required by current GAAP. In addition, we expect to redeem Olympic's $35 million of sub debt. Regulatory capital ratios post closing are expected to remain comfortably above well-capitalized thresholds.

I will now pass the call back to Bryan.

Thanks, Don. To wrap things up, I would just like to restate we are extremely pleased with this unique opportunity to bring Kitsap Bank to the Heritage family. We are excited to join forces and capitalize on the various opportunities that will come from the combination of 2 distinguished bank brand names in the region. It will be fun to watch what we're able to accomplish together.

With that said, Elisa, we can now open the line for questions from call attendees.

[Operator Instructions] Your first question comes from the line of Ryan Payne with D.A. Davidson & Co.

This is Ryan Payne on for Jeff Rulis. Starting with rate sensitivity, does Olympic alter your rate position? I believe you're slightly asset sensitive now.

Yes. Overall, we're fairly neutral. We don't have a lot of movement either way. And actually, Kitsap is very similar in their asset sensitivity. So they're pretty neutral in their interest rate risk sensitivity models. So we're going to fit in right in with them on that.

Got it. Helpful. And on the fee income side, do you see any opportunity to expand or cross-sell any products between the 2 organizations?

Ryan, no, nothing specific to note. Both operating model is pretty similar in terms of the products and services offered. And we didn't model any additional revenue synergies as we were doing our modeling. Of course, over time, we do hope to deploy their liquidity into additional loans. So we do expect that. But outside of that, no specific fee income opportunities.

Got it. Last for me on capital priorities. Do you see any increased appetite for more M&A going forward? I mean this sounds like a pretty specific opportunity. So just anything to add on future appetite and how conversations have been going?

Sure. I guess what I would say is that our first priority is to make sure this transaction is a success. As Don noted, we think we can get the deal closed early in 2026 and be converted the second half of next year. We are continuing to engage in conversations. And if something attractive surfaces, we would consider it as we always do.

The next question comes from Ashley Aloupis with Piper Sandler.

This is Ashley Aloupis on for Matthew Clark. Congrats on the deal guys. So I just want to ask about the cost saves. So you estimate around 35% of cost saves. Can you provide some insight into the sources of these cost saves and kind of the time line for the systems conversion to occur?

Sure. Don, do you want to take that one?

Sure. Well, it's pretty much the standard cost saves. As far as there's going to be obviously, backroom, there's going to be FTE reductions in the backroom, but there's also going to be the systems, the core systems and a lot of other systems that are duplicates, we wouldn't need going forward. So I would say those are probably the key drivers to those cost statements. We're not actually -- there's not a lot of branch overlap, so there's not going to be a lot of closing of branches. But it's mostly going to be both systems and people.

Awesome. So another question, looking at the $10 billion mark, it looks like on a pro forma basis, you'll be around $9 billion in total assets after close. And this seems like a good deal to offset in terms of building some scale and any headwinds associated with crossing the $10 billion mark. And I was wondering if you had any insight into the time line of when you see yourself crossing that $10 billion mark? Or will you try to manage under $10 billion during 2026?

Sure. We do expect to be under $9 billion in assets at closing, still a nice runway for organic growth for several years before reaching the $10 billion mark. We are operationally ready and aware of what's required when we go over $10 billion. We had a strategic initiative back in 2023, where we spent quite a bit of time exploring that at the time our asset levels were in the $7.7 billion, $7.8 billion range. But we're also sensitive to the cost. Our focus is really on maximizing profitability rather than size, and we do have levers to pull if over the next few years, we get close to that $10 billion range. So again, the deal brings us closer, but we still feel like we've got ways to go.

Great. And just one more question from me on -- another one on capital priorities. So your priority is to get the deal kind of closed and integrated successfully. Outside of M&A, where are your capital priorities going forward? You've been pretty active buying back shares in the past few quarters. So do you expect this to continue?

No, we will be putting stock -- share buybacks on hold at least through the date of the merger. Other things, we've also been using capital some for lost trades. We've also put those somewhat on hold as a result. That doesn't mean we wouldn't do anything, but we're -- at this point, we're conserving capital for the deal. And subsequent to the deal, [indiscernible] as we've earned the capital back, then we'll look at potentially getting back into these activities, but we'll have to wait and see on top of that.

The next question comes from the line of David Feaster with Raymond James.

First off, congrats on the deal. When I step back and kind of look at it, I mean, this is -- it's kind of a mini you, right? I mean this is a very similar bank to you all. You've already talked about some of the similar operating models just in terms of products and services. I guess could you just touch on where you see the most opportunity looking forward on a combined basis? Is it mostly just allowing their bankers to leverage a larger balance sheet, maybe move upstream a little bit or gain more wallet share with existing clients? Just kind of curious maybe what you're more excited about coming out of this transaction?

I think it's what you alluded to, David. When we look at combining the 2 banks and compatible cultures and approach to business and then the geography, of course, both organizations very familiar with the other's geography. So with those similarities, you really get higher density, a little bigger, better and deeper into our core markets. The expanded markets that we're moving into certainly have the benefits of an organization with a bit larger scale. So the real upside is in just what you alluded to, which is the similarities, the ability to execute and then both companies being stronger players in our respective markets. The only other thing I would add to that is, as you've seen, Kitsap has lots of liquidity on their balance sheet. And so I think there's an opportunity to deploy a higher percentage of that into loans and generate higher profitability from the combined organization.

And perfect, you just played right into my second question. I was just hoping that you could dig into maybe some of the modeling assumptions that are embedded in that EPS accretion figure. First off, I guess, what rate outlook are you assuming? And then just kind of the balance sheet optimization plans, the growth expectations and kind of what you're planning to do with some of that excess liquidity, just given the optionality and flexibility that you guys have?

Yes. Don, do you want to take that one?

Sure, David. As far as -- I don't think we've had any specific rate assumptions necessarily. We both looked at -- you can look at the analyst forecast consensus and really using some of this as a basis and for Heritage and with some basic growth assumptions and the same with really Kitsap, although we don't have analysts, we still look at where they're at and some really basic growth assumptions on assets and net income. Both of us are -- the margins are growing at both banks. And so we made the assumption that just like our analyst forecasts have or the consensus is that we consider that our NIM will continue to largely increase over the next couple of years. So I think those are the main assumptions I think you're driving at as far as the cost savings that we've kind of stated what those are and those are obviously another big piece of that. Is there anything else on that...

No. Maybe just -- yes, maybe thinking about the growth outlook on a combined basis, they've been kind of growing at that mid-single-digit pace. You all have been kind of talking about getting back towards something like that as well. Just kind of curious how you think about the organic growth outlook, the key drivers once you're including them and whether there's any loan pool purchases or anything else in addition to securities and organic growth that you'd be interested in?

I can take that one, Don. We didn't model anything specific when we were doing the modeling to put the companies together. But that mid-single-digit growth is very achievable in the markets, really obviously dependent on just general economic conditions. But in terms of the bank's ability to participate at the levels we have historically, very confident we can continue to do that.

Okay. Terrific. That's helpful. And just one quick one. I did notice that you mentioned retaining the Kitsap Bank brand. So are those going to remain operating under that brand? Or are they going to be Heritage locations? Just kind of wanted to clarify that.

It will be a DBA similar to what -- how we operate on Whidbey Island. We operate with Whidbey Island Bank, doing Heritage Bank doing business as Whidbey Island Bank. So effectively, it's just the marketing and the signage, all of the systems and legal and kind of if you think of the operating platforms are all the same. But Kitsap has a great reputation, high market share and a lot of value from our perspective and continuing to leverage that brand in those markets where they're really well known. So that's the thought behind that.

The next question comes from the line of Andrew Terrell with Stephens.

Congrats on the deal. Just a couple for me that weren't already addressed. Just going back to approaching that $10 billion threshold or getting a lot closer. Do you have just an estimate or ballpark of what the Durbin impact is if you were to look at both organizations together?

Don, do you have that?

Yes. If we looked out when it occurred, this could be, again, 4 or 5 years down the road, it could be up to close to $7 million.

Got it. Okay. And then I was curious just on -- I'm looking through just the EPS accretion and dilution and everything. I just want to make sure that I'm thinking about this the right way for the model. The baseline for the 2027 EPS accretion expectation, just there's not many consensus estimates out there yet. Are you using consensus for 2027? Or is it an internal baseline that you're calculating accretion off of just as we look to square our models?

For Heritage, we were using consensus.

Okay. And then the last one, do you have a -- I understand you're going to be very well capitalized still going forward. But do you have a specific pro forma CET1? Or just what the CET1 impact is just layering the deal in?

Yes. Let me get that for you here. I think it was -- I don't know, let's see. CET1 at close would be about 11 -- mid-11s.

Got it. Okay. The rest of mine were already addressed...

Real quick on going back on your question. I think we used growth for -- because I don't think 2027 has much consensus out there yet. So we used consensus for '26 and then gave a 5% growth on top of that for the modeling of the earnings.

Got it. Okay. Yes, that makes sense. Yes, I was looking -- I know most of us haven't put out 2027 yet. So I just wanted to make sure we're all thinking about the same base. Great. Well, congratulations on the deal.

[Operator Instructions] Our next question comes from Kelly Motta with KBW.

Congrats on the deal. It looks exciting. Most of my questions have been asked and answered at this point. But I did want to ask, you provided some good detail about the level of credit due diligence that you did. Another real important factor with deals is the people and making sure you have the right people in place. So wondering if you've done any work to identify the frontline producers that you're looking to keep and if there's any contracts or incentives in place to ensure that you remain aligned in that.

Sure. Yes. Good question. I guess I would start by saying that Olympic's CEO and President are both -- have both agreed to stay through a wind-down period post closing, and we've been working closely over the last couple of months. And in addition to obviously planning for today, also a lot of discussion on how to integrate the companies and retain the employees and the customers. In addition, we have signed employment contracts with several of Kitsap Bank's key leaders, and we're excited to have them filling some very important roles here at Heritage. So we have looked at it, Kelly, and feel like we're in a really good spot to continue discussions with the rest of their team over the next few months and put a good plan together to make sure that the integration goes well for everybody.

Awesome. That's really great color there. And then maybe last question for me that's been hit a bit by others is just the liquidity that Kitsap brings, securities will be marked, so that gives you a lot more flexibility to fund growth ahead. You've already been bringing up your loan-to-deposit ratio, redeploying the securities loss trades into loans. Wondering if you could refresh us on how you guys are thinking about that ratio over time, which with the additional flexibility with Kitsap and you've always run a bit more conservatively than others. So I'm just -- want to just make sure I'm thinking about it appropriately as on a go-forward basis.

Sure. Don, do you want to hit on the kind of percentage of securities and, I guess, loan-to-deposit ratio at the same time?

Sure. Kelly, we've certainly been looking to move it up. Obviously, our deposit growth this year has actually outpaced our loan growth. So it's actually come down a little bit. Their loan-to-deposit ratio is lower than ours. And so on the outset, it's going to lower that. But our goal still is to become more leveraged and to get our loan-to-deposit ratio into the mid -- potentially even the high 80% range. So right now, we're in the low 80s, but I think we can easily function in the mid- to high 80s, and that's kind of where we're trying to get to.

Got it. That's helpful. And then maybe last question for me. You touched on the kind of mid-single-digit loan growth that Kitsap was producing. With what Heritage brings maybe with larger lending limits or additional capabilities, is there the potential that the combined franchise can do a bit better than that mid-single-digit growth? Or over the longer term, do you still feel like that's the appropriate outlook here, at least for the intermediate term?

Yes. I think mid- to high single digits or mid-single digits, it's more driven by the level of economic activity in the markets. And last year at Heritage, we had growth of over 10% and came into the year ahead of budget, and it was really the tariffs and some of the other uncertainty along with some payoff activity that dropped that. But I think both organizations, when you look at the market share with reasonable economic activity can certainly produce the kind of the mid-single digits or higher if we have a little stronger economic activity. So I think it's really going to be more of a factor of the economic activity, but we're certainly in a better position with the 2 companies combined than we are separately. So a little bit of an advantage over what we've had before.

The final question comes from the line of [ Don Rhodes ].

First question I was going to ask has been touched upon a moment ago, and that is, will there be any of the senior Kitsap folks integrated into the Heritage executive team? And the second question is, what is the Board of Directors going to look like? Will the Kitsap Board be disbanded and some people join the Heritage Board? Or what's the thinking in that oversight at this point in time?

Sure. So no, there will not be any changes to the Heritage Board as a result of the deal. We arrived at this arrangement deliberately through a series of conversations with Kitsap and the family. It wasn't a hotly negotiated term. It was just the natural outcome we arrived at together. So that short answer is no change to the Heritage Board, but a little bit of additional color there behind it.

There are no further questions at this time. Mr. McDonald, I turn the call back over to you.

Okay. If there's no more questions, then we'll wrap up this call. We thank you again for your time, your support and your interest in our ongoing performance. We look forward to announcing our Q3 earnings later in October. So with that, we'll say goodbye for this morning.