Heritage Financial Corporation (HFWA) Earnings

Management highlights

- Merger Integration * Integration with Kitsap Bank is progressing as planned, with system conversion scheduled for late September 2026. Elevated merger-related expenses will continue through Q3, with expense levels expected to fall post-conversion in Q4. * Q2 2026 was the first full quarter of combined operations following the merger with Olympic Bancorp. - Balance Sheet Management * Total loan originations increased in Q2, but elevated prepayments (rising to $152 million from $119 million in Q1) limited net loan growth. Higher payoff activity was driven by increased business sales and paydowns on legacy Olympic acquisition loans. * The $210 million Q2 deposit decline was driven by seasonal tax outflows, a one-time $67 million short-term deposit withdrawal, and a $48.5 million reduction in brokered CDs as borrowing rates were more attractive. Adjusted for these factors, deposits fell 1.3% in Q2. * Management sold $38 million of lower-yielding securities for a $217,000 pretax loss and reinvested proceeds in higher-yielding securities, raising the investment portfolio yield by 11 basis points. * 372,000 common shares were repurchased in Q2 for $10 million; 424,000 shares remain available under the current repurchase program. - Credit Quality * Credit quality remained strong and stable through H1 2026. Nonaccrual loans totaled $15.5 million (0.27% of total loans) at end-Q2, with nonperforming assets to total assets steady at 0.19% quarter-over-quarter. Net charge-offs on an annualized basis through H1 were 0.03% of total loans, matching 2025 full-year performance. * Criticized loans as a percentage of total loans were stable at 4%, while substandard loans as a percentage of total loans fell to 1.8% from 2.1% in Q1 and 2.4% at end-2025. The total nonowner-occupied CRE loans to total capital ratio was just under 300% at end-Q2, down slightly from 301% in Q1, and management expects it to continue declining to historical levels.

Guidance

- Loan growth: Management expects an annualized loan growth rate in the mid-single-digit range for the next two quarters, assuming prepayment levels remain similar to Q2 2026. - Expenses: Quarterly noninterest expense is projected to be $64 million to $65 million in Q3 2026 (including ~$6 million in merger-related costs), falling to a core run rate of $56 million to $57 million in Q4 2026 after merger activity concludes. Cost savings from the Olympic acquisition are largely realized by Q4, with minimal additional tail savings in 2027. - Net interest margin: Management expects the net interest margin to continue its upward trajectory, but at a more moderate pace than the 8 basis points core increase in Q2. Future margin improvement will be driven primarily by higher yields on new loans and repricing of existing loans, rather than further reductions in deposit costs. - Deposit costs: Management believes it has hit the bottom for interest-bearing deposit costs, and expects gradual increases in deposit costs from current levels due to rising competitive pressure. - Deposit growth: Management expects typical seasonal strength in deposit growth for the second half of 2026, projecting mid-single-digit annualized deposit growth, consistent with loan growth targets. - Stock buybacks: Management will continue to consider share repurchases based on market conditions and capital priorities, with no planned slowdown in activity from Q2 levels.

Segment performance

Heritage Financial operates as a single consolidated commercial banking business, so separate product segment financials are not provided in the transcript. Key consolidated performance metrics for Q2 2026: Net interest margin increased 3 basis points quarter-over-quarter to 3.99% (8 basis points after adjusting for Q1 2026 nonaccrual interest recovery), and increased from 3.51% in Q2 2025. Total loan balances increased $26 million in Q2, with Q2 loan portfolio yield of 5.72%. Total deposits decreased $210 million quarter-over-quarter, and interest-bearing deposit cost fell to 1.67% from 1.71% in Q1. A $921,000 reversal of provision for credit losses was recognized, with net charge-offs of $234,000 for the quarter. All regulatory capital ratios remain above well-capitalized thresholds; the TCE ratio was 9.7% at end-Q2, up from 9.6% in Q1. Commercial lending closed $339 million in new loan commitments in Q2, with an end-of-quarter pipeline of $628 million. Average new commercial loan interest rate in Q2 was 6.44%, up 36 basis points from Q1.

Risks & headwinds

- Rising competition for deposits is putting upward pressure on deposit costs, which could pressure net interest margin if loan yield increases do not fully offset higher funding costs. - While economic challenges have created some pressure on portions of the commercial and industrial (C&I) loan portfolio, management notes that risk has remained manageable to date. - Deposit flows can be impacted by external factors, including customer distributions of excess funds from business sales and shifts of customer funds to non-bank investments if market rates rise, which can create unexpected deposit volatility.

Analyst Q&A

• Q: What is the split between merger costs and core expenses in the Q3 guidance, and how do cost savings add up to the Q4 run rate? /

  A: Q3 total noninterest expense of $64M-$65M includes ~$6M in merger-related costs (e.g., contract cancellation fees, severance). The Q4 run rate of $56M-$57M reflects both the end of most merger costs and realized FTE/contract cost savings, with almost no additional cost savings expected to roll into 2027. The initial annualized cost save target for the Olympic acquisition remains on track, with small incremental costs on the legacy Heritage side offsetting a portion of the savings.

• Q: What is driving the sharp increase in loan originations, and how does management balance competing on price for new business against protecting net interest margin? /

  A: The increase in originations is driven by rising overall loan demand that has been building since mid-2025, paired with active sales team performance, with a larger share of originations coming from construction loans. Management regularly competes on price to win high-quality full commercial relationships, which is not a new shift in strategy. The recent increase in new loan rates is driven primarily by rising underlying benchmark indexes, not aggressive pricing competition.

• Q: What is the outlook for FHLB borrowings that all mature in early July 2026, and how should they be modeled in forecasts? /

  A: The short-term FHLB borrowings were a temporary liquidity buffer to offset Q2 deposit outflows. Management expects borrowings to decline if Q3 deposits grow in line with typical seasonal patterns, and will only take on term borrowings opportunistically if attractive rates are available. Future borrowings will be managed on an as-needed basis for liquidity.

• Q: What additional balance sheet optimization opportunities does management see to further expand margin? /

  A: The largest remaining upside comes from continued asset repricing: new loans and resets on existing loans are originated at materially higher rates than the current average portfolio yield. Raising the relatively low loan-to-deposit ratio a few percentage points will also drive net interest income growth. Small securities optimization trades will continue, but no large repositioning is planned. Share buybacks will remain an active capital use option depending on market conditions.