HERITAGE FINANCIAL CORP quarterly report, Q1 FY2016

Heritage Financial Corporation — Q1 2016 Form 10-Q

Business context and reporting period

Unaudited results for the three months ended March 31, 2016; balance-sheet comparisons are with December 31, 2015. Heritage is a Washington bank holding company operating Heritage Bank, with 63 branches in Washington and the greater Portland, Oregon area. Its business focuses primarily on commercial lending and deposits.

Key financial metrics

MetricQ1 2016 / March 31, 2016Comparable period / prior year-end
Net interest income$32.8 million$32.7 million in Q1 2015
Net interest margin4.04%4.31% in Q1 2015
Noninterest income$7.0 million$8.3 million in Q1 2015
Noninterest expense$26.4 million$26.0 million in Q1 2015
Net income / diluted EPS$9.1 million / $0.30$9.8 million / $0.32 in Q1 2015
Operating cash flow$13.1 million$0.2 million in Q1 2015
Total assets$3.68 billion$3.65 billion at December 31, 2015
Net loans / deposits$2.43 billion / $3.13 billion$2.37 billion / $3.11 billion at December 31, 2015
Cash and cash equivalents$94.0 million$126.6 million at December 31, 2015
Stockholders’ equity$480.2 million; 13.1% of assets$470.0 million; 12.9% at December 31, 2015

Cash and cash equivalents decreased $32.6 million during the quarter. Investing activities used $60.4 million, principally reflecting net loan originations and securities purchases; financing activities provided $14.7 million, mainly from deposit growth. The allowance for loan losses was $29.7 million, or 1.21% of net loans. Junior subordinated debentures were $19.5 million and repurchase-agreement funding was $20.3 million. The Bank reported regulatory capital ratios of 12.4% common equity Tier 1, 10.3% Tier 1 leverage, 12.4% Tier 1 risk-based, and 13.4% total capital, and was categorized as well capitalized.

Material changes versus comparable periods

  • Net income declined $688,000, or 7.0%, year over year. Q1 2015 included a $1.65 million gain on sale of the Merchant Visa portfolio; that gain did not recur.
  • Net interest income edged up 0.3%, but the margin fell 27 basis points to 4.04%. Management attributed pressure to lower loan yields and reduced accretion income on purchased loans; the margin excluding incremental purchased-loan accretion was 3.82%, versus 3.87% a year earlier.
  • Noninterest income declined 16.2%, mainly due to the nonrecurring Merchant Visa gain and lower loan-sale gains. Noninterest expense increased 1.3%; higher compensation and data-processing costs were partly offset by lower other expense, OREO expense, and intangible amortization.
  • Loans grew 2.4% from year-end, with increases in non-owner-occupied commercial real estate, commercial-property construction, and consumer loans. Deposits grew 0.7%; non-maturity deposits rose to 87.0% of deposits.
  • Credit indicators weakened in some respects: nonperforming assets increased to $14.2 million (0.39% of assets) from $11.7 million (0.32%); nonaccrual loans rose to $12.4 million from $9.7 million. Potential problem loans declined to $94.8 million from $110.4 million.

Outlook, commentary, risks, and unusual items

  • Management expects continued downward pressure on net interest margin because of the low-rate environment and projected reduction in higher-yielding purchased loans. The filing provides no quantitative earnings or revenue guidance.
  • Management considered the $29.7 million loan-loss allowance appropriate, while noting that deterioration in borrower or collateral conditions, economic weakness, or regulatory review could require additional provisions and adversely affect earnings.
  • Key disclosed risks include credit and real-estate exposure, interest-rate and yield-curve changes, deposit competition and liquidity, regulatory requirements, acquisition integration, expense control, cybersecurity and third-party service disruptions, and litigation. Management reported no material change to the risk factors in its 2015 Form 10-K.
  • The company reported $312,000 of OREO valuation adjustments in Q1 and said available-for-sale securities’ unrealized losses were primarily rate-related and considered temporary. A $5.7 million increase in other comprehensive income reflected securities valuation changes.
  • The FDIC shared-loss agreements covering acquired loans had terminated in August 2015. The filing states that there were no material pending legal proceedings beyond ordinary routine litigation. Disclosure controls were deemed effective; no material change in internal control over financial reporting was reported.
  • After quarter-end, the board declared a regular $0.12-per-share dividend, payable May 19, 2016. The quarter’s declared dividend was $0.11 per share.

Important facts for investors to verify

  • Whether subsequent filings confirm the expected margin pressure and show how purchased-loan accretion and loan yields evolve.
  • Whether the rise in nonaccrual loans and nonperforming assets persists, and whether charge-offs or provisions increase; review commercial real-estate and construction exposure.
  • Whether deposit growth and liquidity remain sufficient as loans expand and cash balances decline; verify available borrowing capacity and funding costs.
  • Whether reported capital levels and dividend payments remain supported by bank earnings, regulatory requirements, and the Bank’s ability to distribute dividends to the holding company.
  • How much Q1 profitability depended on recurring operations versus the comparison-period Merchant Visa gain and other variable income items.