Business context and reporting period
Heritage Financial Corporation is a Washington bank holding company operating Heritage Bank, with 63 branches in Washington and the greater Portland, Oregon area. Its business centers on commercial lending and deposits, alongside construction, residential mortgage and consumer lending. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2016; balance-sheet comparisons are with December 31, 2015.
Financial performance and position
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Net interest income | $33.1 million | $32.5 million | $65.8 million | $65.1 million |
| Noninterest income | $6.6 million | $6.9 million | $13.6 million | $15.2 million |
| Net income | $8.9 million | $8.7 million | $18.0 million | $18.5 million |
| Diluted earnings per share | $0.30 | $0.29 | $0.60 | $0.61 |
| Net interest margin | 4.00% | 4.19% | 4.02% | 4.25% |
| Efficiency ratio | 66.8% | 66.3% | 66.5% | 64.8% |
- At June 30, total assets were $3.76 billion, up 2.9% from year-end; net loans were $2.50 billion, up 5.2%; deposits were $3.16 billion, up 1.6%.
- Cash and cash equivalents were $98.9 million, down $27.7 million from year-end. Available-for-sale securities were $815.9 million, of which $272.7 million were pledged. Management reported $543.2 million of unpledged securities.
- Total liabilities were $3.27 billion and stockholders’ equity was $490.1 million, or 13.0% of assets. Funding included $33.0 million of FHLB advances (none at year-end), $16.7 million of repurchase agreements and $19.6 million of junior subordinated debentures.
- For the first six months, operating cash flow was $24.4 million, investing cash outflow was $120.6 million and financing cash inflow was $68.6 million; cash declined by $27.7 million.
- The Bank was categorized as well capitalized. At June 30, its ratios included 11.9% common equity Tier 1, 10.3% Tier 1 leverage and 12.8% total capital to risk-weighted assets.
- Dividends declared were $0.12 per share in Q2 and $0.23 per share for the first half. The board declared another regular $0.12 dividend, payable August 18, 2016.
Material changes versus comparable periods
- Q2 net income rose 1.9% year over year, primarily as higher investment-security interest income more than offset lower noninterest income and higher expenses. First-half net income fell 2.8%, including the absence of a $1.65 million Merchant Visa portfolio sale gain recorded in 2015.
- Margin pressure continued: net interest margin fell 19 basis points in Q2 and 23 basis points for the first half. Loan yields and accretion income on acquired loans declined; growth in average loans and securities and lower deposit costs partly offset the effect.
- First-half noninterest expense increased 1.4%, mainly from compensation and employee benefits and occupancy costs, including branch-consolidation lease termination costs. Noninterest income declined 10.9%, largely reflecting the prior-year Merchant Visa gain, with lower loan-sale gains also contributing.
- Credit indicators weakened in some areas. Nonperforming assets rose to $15.4 million (0.41% of assets) from $11.7 million (0.32%) at year-end; nonaccrual loans increased to $13.9 million from $9.7 million. Net charge-offs were $3.6 million for the first half versus $1.8 million a year earlier.
- Potential problem loans declined to $101.2 million from $110.4 million. The allowance for loan losses fell to $28.4 million, or 1.13% of net loans, from $29.7 million, or 1.24%; coverage of nonperforming loans decreased to 205% from 308%.
- Accumulated other comprehensive income rose to $12.3 million from $2.6 million, primarily reflecting higher fair values of available-for-sale securities.
Outlook, commentary, risks and unusual items
- No quantified earnings or growth guidance was provided. Management said the low-rate environment and expected runoff of higher-yielding acquired loans would continue to put downward pressure on net interest margin.
- Management considered the allowance appropriate based on its methodology and information available, but warned that economic deterioration, borrower or collateral changes, or regulatory review could require higher provisions and adversely affect results.
- In June, the Washington Department of Revenue issued preliminary findings in a B&O tax audit of Whidbey for 2010–2014. The preliminary assessment, including interest, was approximately $1.6 million and related substantially to FDIC shared-loss payments. Management said a material loss was not probable at that time, but factual and legal issues remained unresolved and future estimates or payments could affect results.
- Other risks identified include interest-rate and funding changes, competition, credit and real estate conditions, regulatory actions, acquisition integration, operating costs, cybersecurity and third-party provider risks. The filing reported no material change to the risk factors in the 2015 Form 10-K and no material pending litigation beyond ordinary routine matters.
- The Company reported effective disclosure controls and no material changes in internal control over financial reporting during the quarter. It was evaluating the effects of several new accounting standards, including the expected credit loss model; no quantified impact was stated.
Important facts for investors to verify
- Whether rising nonaccrual loans, nonperforming assets and net charge-offs persist, and how they affect the allowance and provision.
- Whether loan growth can offset lower loan yields, reduced purchased-loan accretion and continued net interest margin pressure.
- How the B&O tax audit develops, including the potential amount and timing of any liability.
- Whether deposit growth and available borrowing capacity remain sufficient to fund lending while cash balances have declined and FHLB advances have begun.
- Whether expense growth, branch consolidation costs and loan-sale income affect future efficiency and earnings.