Heritage Financial Corporation — Q3 2019 Form 10-Q
Business context and reporting period
Heritage Financial Corporation is a Washington bank holding company whose principal subsidiary, Heritage Bank, operates 62 branches in Washington and the greater Portland, Oregon area. Its business focuses on commercial lending and deposits, alongside residential, construction, land-development and consumer lending. This unaudited filing covers the three and nine months ended September 30, 2019; balance-sheet comparisons are with December 31, 2018. No acquisitions or mergers were completed in the 2019 periods. Comparisons with 2018 are affected by the Puget Sound and Premier mergers completed in January and July 2018.
Financial performance and position
| Metric | Q3 2019 | Q3 2018 | Nine months 2019 | Nine months 2018 |
|---|---|---|---|---|
| Net interest income | $50.2 million | $51.1 million | $150.6 million | $135.7 million |
| Provision for loan losses | $0.5 million | $1.1 million | $2.8 million | $4.0 million |
| Noninterest income | $8.5 million | $8.1 million | $23.5 million | $23.2 million |
| Noninterest expense | $36.7 million | $39.5 million | $110.8 million | $111.9 million |
| Net income | $17.9 million | $15.5 million | $50.4 million | $36.4 million |
| Diluted earnings per share | $0.48 | $0.42 | $1.36 | $1.04 |
| Net interest margin | 4.21% | 4.41% | 4.29% | 4.26% |
Quarterly net income rose 15.4%; nine-month net income rose 38.4%. Management attributed quarterly growth chiefly to the absence of prior-year merger costs, partly offset by lower net interest income. Nine-month growth primarily reflected higher net interest income, including a larger average loan balance following the 2018 mergers. The efficiency ratio improved to 62.55% for Q3 and 63.67% year to date, versus 66.68% and 70.44%, respectively.
At September 30, 2019, total assets were $5.52 billion, up 3.7% from year-end; net loans were $3.69 billion, up 2.1%; and deposits were $4.56 billion, up 2.9%. Total stockholders’ equity was $804.1 million, or 14.6% of assets. Cash and cash equivalents were $237.0 million. For the first nine months, operating cash flow was $60.8 million, investing cash flow was negative $81.1 million, and financing cash flow was positive $95.4 million.
Loan growth included commercial business loans of $2.96 billion and construction and land-development loans of $245.7 million. The allowance for loan losses was $36.5 million, equal to 0.98% of net loans. The company reported $20.5 million of junior subordinated debentures and $25.9 million of repurchase-agreement funding; it had no FHLB advances outstanding. Available FHLB borrowing capacity was $930.6 million, with $40.4 million available through a Federal Reserve facility. The Bank was reported as well capitalized; its total risk-based capital ratio was 12.6% and the company’s was 12.9%.
Material changes and notable items
- Net interest margin fell 20 basis points year over year in Q3, as loan yields declined and deposit funding costs increased. For the nine-month period, margin rose 3 basis points. Purchased-loan accretion declined to $1.1 million in Q3 and $3.9 million year to date, from $2.6 million and $6.3 million in the comparable 2018 periods; management said this accretion is expected to decline over time as acquired loans mature or pay down.
- Credit quality weakened on key measures: nonaccrual loans increased to $41.5 million from $13.7 million at year-end, and nonperforming assets increased to $42.4 million from $15.7 million. Nonperforming loans were 1.11% of net loans versus 0.37%; allowance coverage of nonperforming loans declined to 87.97% from 255.73%.
- Management linked much of the rise in nonaccruals to seven commercial relationships totaling $31.0 million, including three agricultural relationships totaling $23.9 million. Potential problem loans declined to $85.3 million from $101.3 million, but the filing also reports $46.2 million of previously pass-graded loans downgraded into that category during the period.
- The company recorded a $537,000 Washington State Department of Revenue business-and-occupation tax assessment during Q3. Merger-related costs fell sharply: $0.1 million for the first nine months of 2019 versus $9.1 million in 2018.
- Adoption of the lease accounting standard in January 2019 recognized $26.6 million of right-of-use assets and $27.9 million of lease liabilities at September 30; beginning retained earnings was reduced by $399,000, net of tax.
- The company repurchased 264,712 shares under its plan during Q3 for $6.9 million. The board declared, after quarter-end, a regular dividend of $0.19 and a special dividend of $0.10 per share, payable November 21, 2019.
Outlook, risks and contingencies
The filing provides no quantified earnings or revenue guidance. The company anticipated adopting CECL on January 1, 2020 and was still evaluating its impact; management expected to provide an estimated allowance under CECL in January 2020. It warned that the new model may increase the allowance, but the magnitude was not yet determined.
Management identified interest-rate changes, deposit pricing and competition, economic conditions in its markets, loan demand and credit deterioration as important risks. It cautioned that additional loan-loss provisions may be required if borrower or collateral conditions worsen and that regulatory examinations could result in additional requirements. Other disclosed risks include integration and retention challenges, operating costs, technology and third-party disruptions, litigation, and fair-value estimation. Management reported no material change in interest-rate risk exposure since the 2018 Form 10-K, no material pending litigation beyond routine business matters, and no material changes to previously disclosed risk factors. Disclosure controls were deemed effective; no material change in internal control over financial reporting was reported.
Important facts for investors to verify
- Review subsequent filings for developments in the commercial and agricultural credits that drove the increase in nonaccrual loans, including collateral values, charge-offs, and allowance adequacy.
- Track deposit costs and net interest margin, including the effect of rate changes and the continuing reduction in acquired-loan accretion.
- Check the company’s CECL adoption disclosures for the estimated allowance increase and related effects on capital and earnings.
- Assess whether deposit growth, liquidity facilities, and capital levels remain sufficient as loans and funding costs change.
- Confirm payment of the declared regular and special dividends and monitor future buybacks, subject to regulatory and capital constraints.