Heritage Financial Corporation (NASDAQ: HFWA) — 2020 Form 10-K
Reporting period: Fiscal year ended December 31, 2020. The filing also reports unaudited fourth-quarter results. Heritage is a Washington-based bank holding company operating Heritage Bank, a commercial community bank serving Washington and Oregon.
Financial performance and condition
| Metric | 2020 | 2019 |
|---|---|---|
| Net interest income | $201.0 million | $199.7 million |
| Noninterest income | $37.2 million | $32.5 million |
| Provision for credit losses | $36.1 million | $4.3 million |
| Net income | $46.6 million | $67.6 million |
| Diluted EPS | $1.29 | $1.83 |
| Net interest margin | 3.63% | 4.22% |
| Return on average assets | 0.74% | 1.25% |
| Efficiency ratio | 62.52% | 63.23% |
Fourth-quarter 2020 net income was $23.9 million, or $0.66 per diluted share, compared with $17.1 million, or $0.47 per diluted share, in fourth-quarter 2019. The fourth quarter included a $3.1 million reversal of provision for credit losses.
- Balance sheet: Assets were $6.62 billion, up 19.1%; loans receivable were $4.47 billion gross ($4.40 billion net), up 18.6%; deposits were $5.60 billion, up 22.2%.
- Liquidity: Cash and cash equivalents were $743.3 million, or 11.2% of assets. Unpledged available-for-sale securities were $607.3 million. The Bank reported no FHLB or Federal Reserve advances outstanding and no brokered deposits; available facilities included $991.7 million at the FHLB and $54.3 million at the Federal Reserve.
- Debt and funding: The balance sheet included $20.9 million of junior subordinated debentures and $35.7 million of securities sold under repurchase agreements. Deposits were the principal funding source.
- Cash flow: Operating cash flow was $70.3 million, investing cash outflow was $538.5 million and financing cash inflow was $983.0 million. Cash increased $514.8 million to $743.3 million, principally reflecting deposit growth.
- Capital: Consolidated common equity Tier 1, Tier 1 risk-based, total risk-based and leverage ratios were 12.3%, 12.8%, 14.0% and 9.0%, respectively. The Bank was categorized as well-capitalized.
Material changes versus 2019
- Net income fell 31.1%, chiefly because the credit-loss provision rose by $31.8 million, reflecting estimated pandemic-related losses. Net charge-offs were $3.2 million, broadly similar to 2019.
- The allowance for credit losses on loans reached $70.2 million, or 1.57% of loans, versus $36.2 million and 0.96% at year-end 2019. Excluding PPP loans, the 2020 allowance ratio was 1.87%.
- Nonperforming loans rose to $58.1 million, or 1.30% of loans, from $44.5 million, or 1.18%. Potential problem loans increased to $182.3 million from $87.8 million; management attributed much of the increase to pandemic-related borrower risk downgrades.
- Net interest margin narrowed 59 basis points as market rates fell and low-yielding PPP loans and higher cash balances changed asset mix. Lower funding costs partially offset reduced asset yields.
- Deposits grew sharply, including noninterest-bearing demand deposits, while certificates of deposit declined. Non-maturity deposits increased to 92.9% of deposits from 88.6%.
- Noninterest income increased 14.7%, supported by mortgage-sale gains, investment-sale gains and a $1.9 million life-insurance death benefit. Service charges and other fees declined 13.3%, partly due to lower overdraft and activity-based fees.
- Heritage adopted CECL on January 1, 2020, reducing opening retained earnings by $5.6 million after tax. The accounting change and pandemic estimates affect comparability.
Outlook, management commentary and risks
- Management expected pandemic effects to continue adversely affecting customers and the business during 2021, and said net interest income and margin could remain under pressure in the near term. The filing provides no specific earnings or margin guidance.
- The Bank originated $897.4 million of first-round PPP loans; $715.1 million remained outstanding at year-end, including $15.4 million of deferred net fees. PPP loans generated $19.5 million of interest and fee income in 2020. The Bank had received $159.2 million of forgiveness payments by year-end and a further $124.5 million through February 19, 2021.
- Under the renewed PPP, the Bank had funded 1,724 additional loans totaling $297.1 million as of February 19, 2021. These loans bear 1% interest plus SBA processing fees.
- At year-end, 177 loans totaling $92.5 million remained in payment-deferral modification status. Management reported that 86.1% of loans modified with payment deferrals during 2020 were no longer on deferral by year-end. Active deferrals included $22.9 million of nonaccrual loans and $39.0 million of performing TDR loans.
- Branch optimization: Heritage announced consolidation of nine branches, with one closed in October 2020 and eight more in January 2021, reducing the network from 62 branches at year-end 2019 to 53.
- Key risks include further pandemic-related credit deterioration, concentrated commercial and real-estate lending, regional economic conditions, interest-rate and funding sensitivity, cyber and third-party service disruptions, regulatory changes, and potential goodwill impairment. Goodwill was $240.9 million; management found no impairment in 2020 after interim and annual assessments.
- The company reported no material pending legal proceedings beyond routine litigation. The independent auditor gave unqualified opinions on the financial statements and internal controls; CECL allowance estimation and goodwill impairment were identified as critical audit matters.
Important facts for investors to verify
- How PPP forgiveness, new originations and deposit balances evolve, and the extent to which year-end liquidity reflects temporary pandemic-related cash accumulation.
- Whether nonperforming, potential problem, modified and TDR loans continue to rise, especially in commercial, agricultural, hospitality and other vulnerable borrower segments.
- Whether the $70.2 million loan allowance adequately reflects realized losses and changing economic forecasts; CECL estimates are judgmental and may be revised.
- Whether earnings and net interest margin recover as PPP balances run off and interest rates, asset yields and funding costs change.
- Whether the branch consolidations and spending on the Heritage Direct platform produce expected efficiencies without impairing customer retention or service.
- Whether capital, liquidity and dividend capacity remain strong if credit losses increase; the company’s dividends depend substantially on distributions from the Bank.