Heritage Financial Corporation — Q2 2023 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2023. Heritage Financial is a bank holding company whose subsidiary, Heritage Bank, operates 51 branches across Washington, Oregon and Idaho, focusing primarily on commercial lending and deposits.
Key financial results
Amounts below are in millions of dollars except per-share data and percentages.
| Metric | Q2 2023 | Q2 2022 | Six months 2023 | Six months 2022 |
|---|---|---|---|---|
| Net interest income | $55.8 | $50.0 | $115.7 | $97.0 |
| Net interest margin | 3.56% | 3.04% | 3.73% | 2.94% |
| Provision for (reversal of) credit losses | $1.9 | $(1.2) | $3.7 | $(4.8) |
| Noninterest income | $7.3 | $7.0 | $15.5 | $15.6 |
| Noninterest expense | $41.3 | $35.7 | $82.9 | $71.4 |
| Net income | $16.8 | $18.6 | $37.3 | $38.3 |
| Diluted earnings per share | $0.48 | $0.52 | $1.06 | $1.08 |
| Efficiency ratio | 65.5% | 62.6% | 63.21% | 63.46% |
Financial condition and liquidity
- At June 30, total assets were $7.12 billion, up 1.9% from year-end 2022. Net loans were $4.20 billion, up 4.9%; total investment securities were $2.03 billion, down 3.2%.
- Total deposits were $5.60 billion, down $329.3 million (5.6%) from December 31, 2022. Non-maturity deposits fell 8.2%, while certificates of deposit rose 43.4%. Management attributed deposit declines mainly to reduced market liquidity and rate-sensitive customers moving some non-operating deposits.
- Borrowings were $450 million at quarter-end, all under the Federal Reserve’s Bank Term Funding Program (BTFP); there were none at year-end. The filing reports $2.75 billion of total available liquidity after outstanding borrowings, including Federal Reserve and FHLB capacity, unencumbered available-for-sale securities, cash and correspondent-bank lines. Brokered deposits were $44.7 million, or 0.80% of deposits.
- Six-month operating cash flow was $47.5 million; investing activities used $135.2 million and financing activities provided $92.5 million. Cash and cash equivalents ended at $108.4 million.
- Stockholders’ equity was $819.7 million, or 11.5% of assets. Company and Bank common equity Tier 1 ratios were 12.8%; the Bank was categorized as well-capitalized. AOCI remained a loss of $97.5 million.
Material changes and management commentary
- Quarterly net income declined 9.4% year over year; six-month net income declined 2.7%. Higher net interest income was more than offset by increased credit-loss provision and operating costs. Deposit and borrowing costs rose as rates increased.
- Management reported a 500-basis-point cumulative federal funds rate increase from March 2022 through June 2023 and noted recession expectations, inflation, and a flat or inverted yield curve as potential pressures on loan demand, credit quality, funding costs and liquidity. No earnings or full-year numerical guidance was provided.
- Loans receivable grew $200.5 million from year-end. Commercial and multifamily construction loans increased 43.5% to $307.0 million. Commercial business loans represented 77.9% of the portfolio; office collateral represented 21.9% of owner-occupied and non-owner-occupied CRE loans.
- Nonaccrual loans declined to $4.6 million from $5.9 million at year-end, while loans 90 or more days past due and still accruing increased to $2.3 million from $1.6 million. The allowance for credit losses on loans was $46.4 million, or 1.09% of loans, versus $43.0 million, or 1.06%, at year-end. Management’s allowance assumptions include economic uncertainty, inflation and higher interest rates.
- Noninterest expense increased 15.7% in Q2 and 16.1% for the first half, driven largely by compensation, branch-market expansion, digital services and higher FDIC premiums. The first-half noninterest-income comparison included a one-time $1.6 million gain on sale of Visa Class B shares; a $286,000 net securities-sale loss was also recorded in the first half.
- A sustained share-price decline triggered a May 2023 goodwill impairment assessment; management concluded reporting-unit fair value exceeded carrying value, so no impairment was recorded. Available-for-sale securities had $125.7 million of gross unrealized losses at June 30, largely attributed to interest rates; management recorded no securities credit-loss allowance and said it did not intend, nor expect to be required, to sell before recovery.
- Management said recent bank failures had not materially affected Heritage’s financial condition, customer base, liquidity, capital or risk profile. It described deposits as seasoned and diversified and reported enhanced liquidity and deposit monitoring. It cautioned that industry developments could still pressure liquidity, margins, credit losses, FDIC costs and investor sentiment.
- The Board declared a $0.22-per-share quarterly dividend in July 2023. The Bank’s sale of its Ellensburg branch was expected to close in Q3 2023; $15.9 million of deposits related to the transaction were classified as held for sale at quarter-end.
Risks, contingencies and controls
Principal risks discussed include economic deterioration, CRE and other borrower credit risk, interest-rate and deposit competition, deposit outflows, liquidity access, securities valuation and accumulated unrealized losses, regulatory changes and FDIC assessments, operating costs, and technology or third-party disruptions. The company reported no material pending litigation beyond routine business matters and no material changes to its previously disclosed risk factors. Management concluded disclosure controls were effective and reported no material quarterly change in internal control over financial reporting.
Important facts for investors to verify
- Whether deposit trends, deposit pricing and reliance on the $450 million BTFP borrowing remain manageable in subsequent filings.
- Changes in CRE exposure and performance, particularly office loans, construction lending, past-due loans and allowance adequacy.
- Whether net interest margin holds up as deposit costs reprice and market rates or the yield curve change.
- How operating expenses, efficiency and loan growth develop after staffing and geographic expansion.
- Whether unrealized securities losses, liquidity availability, goodwill valuation or the Ellensburg branch sale change materially.