Heritage Financial Corporation — FY2017 Form 10-K
Business context and reporting period. Heritage is a Washington-based bank holding company whose primary business is community banking through Heritage Bank, serving Washington and the greater Portland, Oregon area. This filing covers the fiscal year ended December 31, 2017; quarterly data below includes fourth-quarter 2017. The Puget Sound Bancorp merger closed January 16, 2018, after year-end, so its operations are excluded from FY2017 results.
Key financial metrics
| Metric | FY2017 / Dec. 31, 2017 | Prior comparable period |
|---|---|---|
| Interest income | $147.9 million | $138.5 million in FY2016 |
| Net interest income | $139.5 million | $132.5 million in FY2016 |
| Net income | $41.8 million; diluted EPS $1.39 | $38.9 million; diluted EPS $1.30 in FY2016 |
| Net interest margin | 3.92% | 3.96% in FY2016 |
| Efficiency ratio | 63.21% | 64.87% in FY2016 |
| Total assets | $4.11 billion | $3.88 billion at year-end 2016 |
| Net loans / deposits | $2.82 billion / $3.39 billion | $2.61 billion / $3.23 billion at year-end 2016 |
| Allowance / nonperforming loans | $32.1 million; 1.13% of net loans and 299.79% of nonperforming loans | $31.1 million; 1.18% and 284.93% at year-end 2016 |
| Cash and cash equivalents | $103.0 million | $103.7 million at year-end 2016 |
| Stockholders’ equity | $508.3 million; 12.4% of assets | $481.8 million; 12.4% at year-end 2016 |
FY2017 net income increased 7.4%. Operating cash flow was $73.5 million, investing cash outflow was $241.4 million, and financing cash inflow was $167.2 million; cash declined $0.7 million during the year. Reported borrowings included $92.5 million of FHLB advances, $31.8 million of repurchase agreements, and $20.0 million of junior subordinated debentures. Deposits were the principal funding source; 88.3% were non-maturity deposits. The Bank and Company met applicable well-capitalized requirements; Company CET1 was 11.3% and total risk-based capital was 12.8%.
Fourth quarter: net income was $10.0 million and diluted EPS was $0.33, versus $9.9 million and $0.33 in Q4 2016. Net interest income was $37.2 million, provision for loan losses $1.3 million, and noninterest income $9.0 million.
Material changes versus prior period
- Loans grew 7.9% and deposits 5.1% year over year; asset growth was 6.0%. Loan growth was concentrated in non-owner-occupied and owner-occupied commercial real estate.
- Net interest income rose 5.3%, supported by higher average earning assets. Net interest margin slipped four basis points as loan yields declined and funding costs increased; interest expense rose 39.0%.
- Noninterest income increased 12.0%, mainly from service charges and fees and loan-sale gains. Noninterest expense rose 3.9%; the efficiency ratio improved.
- Nonperforming loans declined to $10.7 million, or 0.38% of net loans, from $10.9 million, or 0.41%. Net charge-offs were $3.2 million versus $3.6 million in 2016.
- Income tax expense increased to $18.4 million from $13.8 million, including a $2.6 million charge to revalue deferred taxes following enactment of the Tax Cuts and Jobs Act.
Outlook, management commentary, risks and unusual items
- Outlook: The filing provides no formal earnings or revenue guidance. Management’s interest-rate simulation, using a no-growth assumption, estimated that a 100-basis-point rate increase could raise net interest income by $6.4 million in year one and $12.1 million in year two; a 200-basis-point increase could raise it by $12.6 million and $23.9 million, respectively. These are model estimates, not guidance, and depend on assumptions about repricing, prepayments, and deposit behavior. Management noted anticipated further Federal Reserve rate increases in 2018.
- Puget Sound merger: Heritage issued 4.11 million shares for total consideration of $130.8 million. Puget Sound reported $556.0 million in assets, $388.3 million in loans, and $491.9 million in deposits at December 31, 2017. Integration, customer retention, cost savings, and acquisition accounting are key execution items.
- Credit and concentration: Commercial business loans represented 79.1% of the loan portfolio; non-owner-occupied commercial real estate was 34.6%. Management identified economic weakness, real estate values, borrower cash flows, and the adequacy of loan-loss reserves as material risks. Performing troubled debt restructurings were $26.8 million, and potential problem loans were $83.5 million.
- Rates and funding: Rising deposit costs could outpace asset repricing and pressure margins. The portfolio also faces interest-rate valuation risk. The filing notes that LIBOR is expected to be replaced after 2021, with effects on linked instruments uncertain.
- Other material items: The company reported $119.0 million of goodwill and no 2017 impairment. CECL adoption was anticipated for January 1, 2020; management said the effect was still being assessed and could increase the allowance. A Washington State B&O tax audit matter was resolved in January 2018 with no payment due. The filing reports no material pending litigation beyond routine business matters.
- Controls and audit: The independent auditor issued an unqualified opinion on the financial statements and reported effective internal control over financial reporting as of year-end.
Important facts for investors to verify
- How the Puget Sound integration affects costs, deposit retention, loan growth, and tangible book value after closing.
- Whether credit quality and reserve coverage remain adequate as commercial real estate and other commercial exposures grow; monitor criticized, potential problem, nonaccrual, and restructured loans.
- Whether deposit pricing and other funding costs erode net interest margin as rates change, and compare actual results with the filing’s interest-rate sensitivity assumptions.
- The final tax effects of the Tax Act and subsequent measurement-period adjustments, plus the eventual CECL impact on reserves and capital.
- Liquidity and capital after the merger, including use of FHLB advances, dividend capacity, and the effect of shares issued in the transaction.