Heritage Financial Corporation, the Olympia, Washington-based bank holding company for Heritage Bank, reported a "solid core performance" in their Q1 2024 earnings call. Loan growth was touted as strong, running at an 8.4% annualized rate. Credit quality was presented as consistently strong. But a closer look at the Q1 2024 earnings call transcript reveals a potential risk simmering beneath the surface: construction loans.

While construction loans are a normal part of any bank's portfolio, Heritage Financial's heavy reliance on them in Q1, combined with a projected surge in payoffs in Q2, creates a volatile situation that could significantly impact their future performance. This potential vulnerability seems to have flown under the radar of most analysts, who focused primarily on the headline numbers and the impact of deposit pricing and balance sheet restructuring.

Here's the Breakdown:

Q1 loan growth was heavily fueled by construction loans: Both Jeff Deuel, CEO of Heritage Financial, and Bryan McDonald, President and Chief Operating Officer, acknowledged that a significant portion of the celebrated loan growth was due to "construction loans that we've had waiting to fund." This indicates that the robust 8.4% annualized loan growth rate might be overstating the actual organic loan demand from customers. Q2 anticipates a high level of construction loan payoffs: McDonald stated that they "anticipate a higher projected level of construction loan payoffs in the second quarter," attributing this primarily to low-income housing projects being paid off through tax credit equity. This rapid transition from heavy funding to heavy payoffs in just one quarter creates a significant swing in the loan portfolio. This swing introduces uncertainty: The Q1 reliance on construction loan funding and the Q2 prediction of a wave of payoffs present a highly unusual and volatile dynamic. It's unclear how much of the Q1 growth will be negated by the Q2 payoffs. This makes it difficult to project a sustainable loan growth rate for the rest of the year.

The Hypothesis:

We hypothesize that the significant payoff of construction loans in Q2 could result in a substantial contraction of the loan portfolio, potentially offsetting much of the Q1 growth. This would severely impact Heritage Financial's net interest income, further pressuring their already-strained margin.

Supporting Numbers:

Unfortunately, the exact proportion of Q1 loan growth attributed to construction loan funding is not explicitly stated in the transcript. However, the language used by both Deuel and McDonald suggests it was a significant driver, potentially even the majority. Additionally, while the Q2 investor presentation provides a detailed breakdown of loan growth by segment, it doesn't differentiate between newly originated loans and funding of existing construction commitments. This lack of transparency makes it impossible to confidently estimate the potential impact of the Q2 construction loan payoffs.

Visualizing the Volatility: Construction Loan Activity

To understand the potential impact of the construction loan payoff surge, let's look at a hypothetical representation of construction loan activity in Q1 and Q2.

The Implications:

If our hypothesis proves true, Heritage Financial's loan growth narrative, a key positive takeaway from the Q1 earnings call, will be significantly undermined. Analysts currently projecting continued mid-single-digit loan growth for the year may need to revise their estimates downwards.

Furthermore, a shrinking loan portfolio would exacerbate the challenges Heritage Financial faces on the margin front. Don Hinson, CFO, admitted that they "expect to continue to experience an increase in the cost of our core deposits" and that margin stabilization is dependent on "maintaining deposit balances." A drop in earning assets due to construction loan payoffs would further complicate their efforts to stabilize their NIM.

Conclusion:

While Heritage Financial's Q1 earnings call presented an optimistic picture, the hidden volatility within their construction loan portfolio creates a potential ticking time bomb that could detonate in Q2. Investors and analysts should pay close attention to the Q2 loan growth numbers, as they may reveal a much different reality than the one presented in the recent earnings call.

Key Takeaways and Fun Facts: