Heritage Financial Corporation — Q2 2014 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2014. The Washington Banking Company merger closed May 1, 2014; reported results include two months of its operations, so year-over-year comparisons are materially affected by the acquisition.
Business context and financial performance
Heritage Financial is a Washington-based bank holding company whose subsidiary operates 67 branches in Washington and the greater Portland, Oregon area, focusing primarily on commercial banking, lending, and deposits.
- Q2 results: Net interest income was $28.6 million, up 79.4% year over year; net income was $4.1 million, up 54.2%; diluted EPS was $0.16 versus $0.18. Total interest income was $30.0 million and noninterest income was $4.8 million.
- Six-month results: Net interest income was $45.3 million, up 39.6%; net income was $6.7 million, up 20.0%; diluted EPS was $0.32 versus $0.37. Total interest income was $47.6 million and noninterest income was $7.1 million.
- Margins and efficiency: Net interest margin fell to 4.55% in Q2 from 4.82% a year earlier and to 4.52% for six months from 5.00%. The efficiency ratio rose to 80.9% for Q2 and 79.7% for six months, principally reflecting merger-related operating costs.
- Balance sheet at June 30: Total assets were $3.39 billion; net loans were $2.20 billion; deposits were $2.87 billion; and stockholders’ equity was $449.8 million. Assets, loans, and deposits increased substantially from year-end primarily because of the merger.
- Cash flow, six months: Operating activities provided $6.8 million; investing activities used $17.8 million; financing activities provided $27.1 million. Cash and cash equivalents ended at $146.5 million.
- Funding and capital: Repurchase-agreement borrowings were $25.5 million and the company assumed $19.0 million of junior subordinated debentures in the merger. The Bank’s Tier 1 leverage, Tier 1 risk-based, and total risk-based capital ratios were 12.4%, 14.3%, and 15.5%, respectively; it was categorized as well capitalized.
Material changes and asset quality
- The May 1 merger added approximately $1.66 billion of assets and $1.43 billion of deposits at preliminary fair value. Heritage issued 13.98 million shares and paid cash; the reported consideration was approximately $270.1 million. The preliminary purchase accounting recorded $88.8 million of goodwill.
- Q2 and six-month noninterest expense was $27.0 million and $41.8 million, respectively. Merger-related costs were $5.3 million in Q2 and $5.6 million for six months. The merger contributed higher compensation, data-processing, and professional-services costs.
- Noncovered nonperforming loans were $13.6 million, versus $7.7 million at year-end; noncovered nonperforming assets were $18.6 million, or 0.58% of noncovered assets. Noncovered potential problem loans rose to $137.0 million from $52.8 million, primarily because $83.0 million was acquired in the merger.
- The total allowance for loan losses was $28.5 million, including $22.4 million for noncovered loans and $6.1 million for covered loans. The noncovered allowance was 1.08% of noncovered loans, down from 1.94% at year-end, partly because acquired loans were recorded at fair value.
- Covered past-due loans increased after the acquisition; these portfolios are subject to FDIC shared-loss arrangements. Management recorded $45,000 of securities impairment expense for the six months, all related to credit impairment of held-to-maturity securities.
Outlook, risks, contingencies, and unusual items
- Management targets cost savings of approximately 10% of the combined company’s noninterest expense. Savings are expected mainly from staffing reductions and eliminating duplicate processes and services; they are not expected to be fully realized until after the core-system conversion anticipated in Q4 2014.
- Management expects net interest margin to continue declining, citing the low-rate environment and anticipated principal reductions in higher-yielding purchased loans. The filing does not provide quantified earnings guidance.
- Key risks include loan-credit deterioration and possible additional provisions, interest-rate and margin changes, integration execution and realization of expected synergies, regulatory capital and liquidity requirements, and potential goodwill impairment. Basel III requirements were scheduled to begin applying in 2015, with provisions phased in through 2019.
- A shareholder class-action lawsuit concerning the Washington Banking merger was subject to a settlement-in-principle memorandum; definitive settlement and court approval were not assured. The company stated that it and the other defendants denied the allegations.
- Subsequent events: shareholders approved a 2014 equity plan authorizing up to 1.5 million shares. The Board declared a $0.09-per-share dividend payable August 21, 2014.
Important facts for investors to verify
- Whether merger integration and the Q4 system conversion proceed as planned, and whether the targeted 10% cost savings are achieved.
- How much reported growth and earnings reflect acquired operations versus organic performance, and how purchase-accounting accretion affects future net interest income.
- Trends in net interest margin, the $137.0 million of potential problem loans, nonperforming assets, charge-offs, and allowance adequacy.
- Deposit stability, available liquidity, and the effect of interest-rate changes on asset yields, funding costs, and capital.
- Final purchase-price allocation, goodwill recoverability, and the outcome of the merger-related shareholder litigation.