HERITAGE FINANCIAL CORP annual report, FY2023

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Heritage Financial Corporation (NASDAQ: HFWA) — 2023 Form 10-K

Reporting period: Fiscal year ended December 31, 2023; comparisons are primarily with fiscal 2022. Heritage is a Washington bank holding company whose single reportable segment is Heritage Bank, a community bank operating 50 branches in Washington, Oregon, and Idaho. Its business centers on commercial lending and deposit relationships.

Financial performance and condition

  • Earnings: Net income was $61.8 million, or $1.75 per diluted share, down 24.6% from $81.9 million, or $2.31 per diluted share. Income before taxes fell 26.7% to $72.9 million; the effective tax rate declined to 15.3% from 17.7%.
  • Net interest: Net interest income rose 2.6% to $225.2 million. Net interest margin increased to 3.58% from 3.35%, as asset yields rose faster than funding costs. Interest expense increased sharply to $59.3 million from $8.1 million, reflecting deposit repricing and $500 million of borrowings.
  • Credit: Total provision for credit losses was $4.3 million, versus a $1.4 million reversal in 2022. The loan allowance was $48.0 million, or 1.11% of loans, compared with $43.0 million, or 1.06%. Nonaccrual loans were $4.5 million (0.10% of loans), down from $5.9 million; nonperforming loans were $5.8 million. Net recoveries were $0.3 million.
  • Revenue and expenses: Noninterest income decreased 36.9% to $18.7 million, mainly due to a $12.2 million securities-sale loss. Noninterest expense rose 10.4% to $166.6 million, including higher compensation, occupancy, data processing, professional services, and FDIC premiums.
  • Balance sheet: Total assets increased 2.8% to $7.17 billion. Net loans grew 7.0% to $4.29 billion. Deposits declined 5.5% to $5.60 billion; non-maturity deposits were 87.6% of deposits, down from 94.8%. Certificates of deposit increased 125.3% to $693.0 million.
  • Funding and liquidity: Cash and cash equivalents were $225.0 million. The Bank had $500 million outstanding under the Federal Reserve’s Bank Term Funding Program, maturing in 2024, and reported $1.42 billion of available FHLB capacity and about $819.5 million of FRB capacity, subject to collateral and eligibility. Uninsured deposits were approximately $2.10 billion.
  • Cash flow: Operating activities provided $109.5 million; investing activities used $93.4 million; financing activities provided $105.3 million. Cash and cash equivalents increased $121.4 million during the year.
  • Capital and shareholder returns: Consolidated CET1, leverage, Tier 1, and total capital ratios were 12.9%, 10.0%, 13.3%, and 14.1%, respectively; the Bank was categorized as well-capitalized. Stockholders’ equity was $853.3 million, or 11.9% of assets. The 2023 dividend was $0.88 per share; the declared quarterly rate entering 2024 was $0.23.

Material changes versus 2022

  • Higher net interest income and margin were more than offset by the securities-sale loss, higher operating costs, and the shift from a credit-loss reversal to a provision, reducing net income by 24.6%.
  • The Company sold $219.7 million of available-for-sale securities at an estimated weighted-average book yield of 2.42% and purchased $178.4 million at an estimated 5.77% yield, recognizing a $12.2 million pretax loss as it repositioned the portfolio to improve future earnings.
  • Deposits declined by $325.0 million, while $500 million of FRB borrowing was outstanding at year-end. Management attributed deposit pressure to competition and rate-sensitive customers moving funds into higher-yielding products; certificates also included $115 million of brokered deposits.
  • Loans grew $284.8 million, led by commercial and multifamily construction and land development loans, which increased 40.9% to $414.4 million. CRE loans totaled $2.66 billion, including $555.8 million secured by office properties.
  • Available-for-sale securities had a $93.4 million difference between amortized cost and fair value at year-end; held-to-maturity securities had a $77.0 million difference between amortized cost and fair value. AOCI loss improved to $72.5 million from $99.9 million.

Outlook, risks, contingencies, and unusual items

  • The filing provides no specific earnings or revenue guidance. Management describes a strategy of disciplined growth, commercial relationship banking, deposit growth, asset quality, and selective expansion. It said liquidity and capital resources were adequate for foreseeable needs.
  • Key risks include interest-rate and deposit competition, liquidity and funding access, economic weakness in the Pacific Northwest, and credit exposure to commercial real estate and construction. The loan book is concentrated in commercial business lending (77.8%); owner- and non-owner-occupied CRE equals 61.2% of loans. Management reported construction, land development, and land loans at 53% of regulatory capital and CRE loans, as defined by the FDIC, at 271%.
  • Outstanding commitments to extend credit were $1.27 billion. The Company also had $107.9 million of unfunded LIHTC commitments, with $29.5 million expected to be funded in 2024. These are commitments, not current funded loans.
  • Other notable items included a $1.6 million gain from selling Visa Class B shares and a $610,000 gain on the Ellensburg branch sale; these partly offset weaker noninterest income. The Company ceased originating residential mortgages for secondary-market sale in January 2024.
  • The 12-month interest-rate simulation estimated net interest income changes of +0.6% under a +200-basis-point shock and +0.8% under a −100-basis-point shock. The filing cautions that model assumptions limit the estimates’ predictive value.
  • The company reported no material cybersecurity incidents and no material pending litigation beyond routine matters. The independent auditor issued an unqualified opinion and concluded internal control over financial reporting was effective. The allowance for credit losses’ qualitative component was identified as a critical audit matter.

Important facts for investors to verify

  1. Whether deposit balances, deposit pricing, and reliance on certificates, brokered deposits, and FRB borrowing improve or deteriorate after year-end, including repayment of the $500 million BTFP advance due in 2024.
  2. Trends in CRE and construction loan performance, criticized or classified exposures, modifications, collateral values, and allowance adequacy, particularly given portfolio concentrations and rapid construction-loan growth.
  3. Whether the securities repositioning improves recurring earnings as higher-yielding assets replace sold securities, and how unrealized securities losses affect capital and liquidity under actual conditions.
  4. Whether higher funding costs, operating expenses, and credit provisions continue to offset asset-yield benefits; the filing does not provide quantified forward guidance.
  5. The sustainability of dividends and repurchases given earnings, capital needs, and the Bank’s capacity to distribute dividends to the holding company.