Heritage Financial Corporation — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018; unaudited. Heritage Financial is a Washington-based bank holding company operating Heritage Bank, with 64 branches in Washington and the greater Portland, Oregon area. Its business is primarily commercial lending and deposit-taking.
Financial performance and condition
| Metric | Q3 2018 | Q3 2017 | First nine months 2018 | First nine months 2017 |
|---|---|---|---|---|
| Net interest income | $51.1 million | $34.9 million | $135.7 million | $102.2 million |
| Provision for loan losses | $1.1 million | $0.9 million | $4.0 million | $2.9 million |
| Noninterest income | $8.1 million | $8.4 million | $23.2 million | $26.5 million |
| Noninterest expense | $39.6 million | $28.0 million | $112.1 million | $83.0 million |
| Net income | $15.5 million | $10.6 million | $36.4 million | $31.8 million |
| Diluted earnings per share | $0.42 | $0.35 | $1.04 | $1.06 |
| Net interest margin | 4.41% | 3.86% | 4.26% | 3.89% |
Q3 net income rose 45.9%; nine-month net income rose 14.7%. Nine-month EPS declined despite higher net income, while the share count increased substantially, principally because of merger consideration. The nine-month effective tax rate was 15.0%, compared with 25.9% in 2017, primarily reflecting the Tax Cuts and Jobs Act.
- Assets and loans: Total assets were $5.28 billion at September 30, up 28.3% from December 31, 2017. Net loans were $3.61 billion, up 28.3%; commercial business loans were about 80% of gross loans.
- Credit quality: Allowance for loan losses was $34.5 million, or 0.94% of net loans. Nonaccrual loans were $14.8 million versus $10.7 million at year-end; nonperforming assets were $16.8 million, or 0.32% of assets. Potential problem loans increased to $105.7 million from $83.5 million.
- Deposits and borrowings: Deposits were $4.40 billion, up 29.6%, largely from acquisitions. Non-maturity deposits were 88.5% of deposits. No FHLB advances were outstanding at quarter-end, compared with $92.5 million at December 31, 2017. The company also had $32.2 million of repurchase agreements and $20.2 million of junior subordinated debentures.
- Liquidity and cash flow: Cash and cash equivalents were $170.1 million. For the first nine months, operating cash flow was $55.4 million, investing cash outflow was $42.8 million, and financing cash flow was $54.5 million. The Bank reported $826.8 million of available FHLB borrowing capacity and $45.2 million of Federal Reserve capacity; neither facility had advances outstanding.
- Capital: Stockholders’ equity was $746.1 million, or 14.1% of assets. The Bank was categorized as well capitalized; its actual common equity Tier 1 ratio was 11.5% and total capital ratio was 12.3%.
Material changes and notable items
- Heritage completed the Puget Sound Bancorp acquisition on January 16, 2018 and Premier Commercial Bancorp on July 2, 2018. Together, the acquisitions added approximately $1.08 billion of assets at their respective closing-date fair values and contributed $121.8 million of goodwill. Purchase-price allocations remained preliminary.
- Acquisitions drove much of the growth in interest income, loans, deposits, staffing and expenses. Nine-month acquisition-related costs were $9.1 million. Management also recorded a $1.7 million buyout of a third-party contract and expected future savings to offset that cost by the end of 2019.
- Rising rates and loan growth lifted asset yields and net interest margin, while the cost of interest-bearing liabilities also increased. Purchased-loan discount accretion contributed $6.3 million to nine-month interest income; management said the contribution is expected to decline as purchased loan balances run off.
- Nine-month noninterest income fell 12.5%, mainly because 2017 included a $3.0 million gain on sale of a purchased credit-impaired loan and loan-sale activity was lower. Q3 other income included a $382,000 gain on sale of a branch held for sale.
- Available-for-sale securities had $20.7 million of gross unrealized losses at September 30, primarily attributed to rising market rates; management did not consider the declines other-than-temporary. Accumulated other comprehensive loss was $14.7 million.
Outlook, risks and contingencies
The filing provides no numerical earnings or financial guidance. Management described growth through the acquisitions and commercial banking expansion as strategic priorities. It considered the allowance adequate based on its methodology, but cautioned that economic deterioration, borrower and collateral performance, or regulatory review could require additional provisions. Other disclosed risks include integration and customer or employee retention, interest-rate and funding sensitivity, loan concentrations and real estate conditions, competition, regulation, litigation, and technology or third-party service disruptions. Management reported no material change to the risk factors in the 2017 Form 10-K, no material pending legal proceedings beyond routine litigation, and effective disclosure controls.
The Board declared after quarter-end a regular dividend of $0.17 per share and a special dividend of $0.10 per share, payable November 21, 2018. The company anticipated adopting the new lease standard in 2019 and CECL in 2020; the expected CECL impact had not yet been determined.
Important facts for investors to verify
- Whether the two acquisitions are integrated as planned and whether anticipated efficiencies offset higher operating costs and the reported merger expenses.
- Whether the increase in potential problem loans and nonaccrual loans signals further credit deterioration, and whether the allowance remains adequate as acquired loans season.
- How much future net interest income depends on purchased-loan accretion, and how deposit pricing and interest-rate changes affect margin.
- Whether deposit growth, liquidity resources and capital remain sufficient as the enlarged loan portfolio and branch footprint develop.
- Final acquisition purchase-price allocations and the eventual allowance impact of CECL adoption.