Heritage Financial Corporation — Q2 2018 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2018. Heritage is a Washington bank holding company operating Heritage Bank, focused primarily on commercial lending and deposits in Washington and the greater Portland, Oregon area. Results include Puget Sound Bancorp from its January 16, 2018 acquisition date.
Key financial results
| Metric | Q2 2018 | Q2 2017 | Six months 2018 | Six months 2017 |
|---|---|---|---|---|
| Net interest income | $43.7 million | $34.1 million | $84.6 million | $67.3 million |
| Noninterest income | $7.6 million | $10.7 million | $15.1 million | $18.1 million |
| Net income | $11.9 million | $11.8 million | $20.9 million | $21.1 million |
| Diluted EPS | $0.35 | $0.40 | $0.62 | $0.71 |
| Net interest margin | 4.22% | 3.92% | 4.17% | 3.91% |
| Efficiency ratio | 69.58% | 62.01% | 72.67% | 64.49% |
Q2 net interest income plus noninterest income was $51.3 million, compared with $44.8 million a year earlier. For the first half, the comparable total was $99.7 million versus $85.3 million. Net income was nearly flat for Q2 and down 0.9% for the first half; diluted EPS declined in both periods, with the higher share count following the Puget Sound stock issuance.
- June 30 balance sheet: Assets were $4.79 billion, up 16.4% from year-end 2017; net loans were $3.29 billion, deposits $3.97 billion, and stockholders’ equity $639.5 million.
- Liquidity and funding: Cash and cash equivalents were $129.9 million. Available-for-sale securities were $873.7 million, including $615.8 million not pledged. Deposits were the principal funding source. Borrowings included $75.5 million of FHLB advances, $22.2 million of repurchase agreements, and $20.2 million of junior subordinated debentures.
- Cash flow, six months: Operating activities provided $29.7 million; investing activities used $34.3 million; financing activities provided $31.4 million. Ending cash and cash equivalents were $129.9 million.
- Credit and allowance: Allowance for loan losses was $34.0 million, or 1.02% of loans, versus $32.1 million, or 1.13%, at year-end. Nonaccrual loans rose to $16.5 million from $10.7 million; nonperforming assets were 0.35% of assets versus 0.26%. Potential problem loans increased to $101.5 million from $83.5 million.
Material changes and notable items
- Puget Sound added $388.5 million of loans, $505.9 million of deposits, and $68.5 million of goodwill at acquisition. Management attributed much of the growth in interest income, expenses, assets, and deposits to the merger. Excluding acquired loans, net loans grew at a 6.4% annualized rate; deposits excluding the acquisition grew at a 4.2% annualized rate.
- Net interest margin improved as asset yields rose, although deposit and borrowing costs also increased. Purchased-loan accretion contributed 0.19 percentage points to Q2 margin and 0.18 points for the first half; management expects this contribution to decline as purchased loans run off.
- Noninterest income fell, mainly because 2017 included a $3.0 million gain on sale of a purchased credit-impaired loan. Noninterest expense rose with merger-related costs and operating scale. First-half acquisition costs were $5.7 million; Q2 also included a $1.7 million third-party contract buyout. Management expects future professional-services savings to offset the buyout cost by the end of 2019.
- Nonaccrual loans increased in part because three agricultural loan relationships were placed on nonaccrual. Management reported two were well-secured; the third was partly SBA-guaranteed. The allowance-to-loans ratio declined partly because acquired loans were recorded at fair value without an initial allowance.
- On July 2, 2018, after quarter-end, Heritage completed the Premier Commercial acquisition, issuing approximately 2.85 million shares for total consideration of $99.3 million. At June 30, Premier had $381.7 million of assets, $335.3 million of loans, and $319.3 million of deposits. Purchase accounting fair values were not finalized in the filing.
- The Bank was categorized as well capitalized. At June 30, its common equity Tier 1, Tier 1 leverage, Tier 1 risk-based, and total risk-based capital ratios were 11.3%, 10.0%, 11.3%, and 12.2%, respectively.
Outlook, risks, and contingencies
- The filing provides no specific earnings or financial guidance. Management emphasizes the sensitivity of net interest income to market rates, funding costs, asset mix, and the yield curve.
- Key risks include credit deterioration, concentrations in commercial lending and real estate, economic or property-market weakness, rising funding costs, and the adequacy of the allowance for loan losses. Management notes that regulatory review could require additional reserves.
- Integration of Puget Sound and Premier carries execution, customer-retention, employee-retention, cost, and synergy risks. The filing also identifies operational and technology disruption, competition, regulatory changes, and litigation as risks.
- Heritage planned to adopt the current expected credit loss standard (CECL) on January 1, 2020; the potential allowance impact was not yet quantified, though management stated it could increase the allowance. The company expected lease accounting adoption in 2019 to increase reported assets and liabilities, without a significant overall financial statement impact.
- Management reported no material pending legal proceedings beyond routine litigation, no material risk-factor changes from the 2017 Form 10-K, and effective disclosure controls as of June 30, 2018.
Investor verification priorities
- Track nonaccrual and potential problem loans, particularly agricultural credits, and assess whether the allowance remains adequate as the loan portfolio expands.
- Separate recurring earnings from acquired-loan accretion, merger costs, the contract buyout, and the prior-year $3.0 million loan-sale gain.
- Monitor whether integration costs subside and whether management achieves the projected professional-services savings by the end of 2019.
- Review Premier purchase accounting, integration progress, and realized cost or revenue synergies when subsequent filings provide updated information.
- Assess the effect of interest-rate movements on loan yields, deposit pricing, net interest margin, and securities values; available-for-sale securities had $17.1 million of gross unrealized losses at quarter-end, which the company attributed primarily to rate increases.