Heritage Financial Corporation — Q1 2015 Form 10-Q
Reporting period: Three months ended March 31, 2015; unaudited consolidated results. Heritage Financial is a Washington-based bank holding company operating Heritage Bank, with 66 branches in Washington and the greater Portland, Oregon area. Its business centers on commercial lending and deposits.
Financial performance and position
| Metric | Q1 2015 | Prior period / comparison |
|---|---|---|
| Net interest income | $32.7 million | $16.7 million, up 95.2% |
| Noninterest income | $8.3 million | $2.3 million |
| Noninterest expense | $26.0 million | $14.8 million |
| Provision for loan losses | $1.2 million | $0.5 million |
| Net income | $9.8 million | $2.5 million, up 284.5% |
| Diluted earnings per share | $0.32 | $0.16 |
| Net interest margin | 4.31% | 4.48%, down 17 basis points |
| Efficiency ratio | 63.5% | 77.6% |
| Operating cash flow | $0.2 million | $5.5 million |
The Q1 2014 comparison excludes Washington Banking Company, which Heritage acquired effective May 1, 2014; Q1 2015 includes three months of the acquired business, so year-over-year growth is substantially acquisition-driven. Q1 2015 noninterest income included a $1.7 million gain from selling the merchant Visa portfolio, $1.1 million in loan-sale gains, and $0.5 million in investment-security gains. Management said the Visa sale would reduce future merchant Visa income.
Balance sheet at March 31, 2015: Total assets were $3.46 billion, up slightly from year-end 2014. Net loans were $2.26 billion; deposits were $2.91 billion; stockholders’ equity was $462.5 million, or 13.4% of assets. Cash and cash equivalents fell to $80.1 million from $121.6 million at year-end. Deposits rose $6.1 million; non-maturity deposits represented 83.2% of deposits, up from 81.9%. Certificates of deposit declined to $490.2 million from $525.4 million.
Funding and capital: Federal Home Loan Bank advances were $7.4 million at quarter-end and were repaid one day after borrowing; repurchase-agreement funding was $23.2 million, down $9.0 million from year-end. Junior subordinated debentures were $19.2 million. Management reported available FHLB, Federal Reserve and correspondent-bank facilities. Heritage Bank was categorized as well capitalized; its reported common equity Tier 1, Tier 1 leverage and total capital ratios were 13.1%, 10.4% and 14.2%, respectively.
Material changes and credit quality
- Net loans grew $37.2 million from December 31, 2014, chiefly through commercial real estate lending; covered loans declined $8.6 million.
- The allowance for noncovered loan losses was $22.3 million, or 1.03% of noncovered loans. Noncovered net charge-offs were $1.1 million, compared with net recoveries of $0.2 million in Q1 2014.
- Nonperforming noncovered assets declined to $8.8 million from $9.7 million; nonperforming noncovered loans were 0.34% of total noncovered loans. Potential problem loans fell to $100.4 million from $117.3 million.
- Other real estate owned rose to $4.1 million from $3.4 million. The quarter included $330,000 of valuation adjustments; six properties were written down based on estimated sale proceeds.
Outlook, risks and unusual items
- No quantified earnings or growth guidance is provided. Management expects continued downward pressure on net interest margin, citing the low-rate environment and projected reduction in higher-yielding purchased loans.
- Management attributed higher earnings and operating scale primarily to the Washington Banking merger and anticipated lending opportunities, low-cost deposits, cost savings and revenue opportunities. The filing does not quantify future merger synergies or their timing.
- Key stated risks include credit deterioration and potentially inadequate loan-loss reserves; local or national economic weakness; interest-rate and funding changes; regulatory actions and capital requirements; acquisition integration and goodwill impairment; competition; litigation; and cybersecurity or third-party service disruptions.
- Q1 operating cash flow was only $0.2 million; investing cash outflow was $41.4 million and financing cash outflow was $0.4 million. Cash and equivalents consequently declined by $41.6 million. The company said it maintains liquidity through deposits, loan and securities cash flows, and available borrowing facilities.
- A Washington Banking shareholder lawsuit was settled and dismissed in February 2015; plaintiffs’ counsel received $450,000 in fees and expenses. The company denied wrongdoing and said the settlement did not change merger consideration.
- The board declared a subsequent quarterly dividend of $0.11 per share on April 22, 2015, payable May 21, 2015.
Important facts for investors to verify
- How much of earnings growth and improved efficiency is sustainable beyond the merger-related increase in scale and one-time or portfolio-sale gains.
- Whether net interest margin continues to contract and how purchased-loan accretion and prepayments affect future earnings.
- Trends in criticized, impaired and restructured loans, charge-offs, collateral values and reserve adequacy, particularly in commercial real estate and construction lending.
- Whether merger integration delivers the anticipated savings and revenue opportunities, and whether integration or goodwill-related costs emerge.
- Liquidity, deposit mix and capital capacity, including the effects of planned dividends, repurchases and evolving regulatory capital requirements.