Heritage Financial Corporation — 2014 Form 10-K
Business context and reporting period. This filing reports the fiscal year ended December 31, 2014, with unaudited fourth-quarter results. Heritage is a Washington-based bank holding company operating Heritage Bank, with 66 branches in Washington and Oregon. Its community banking business focuses primarily on commercial lending and deposits. Results include Washington Banking Company from its May 1, 2014 merger date; year-over-year comparisons are substantially affected by that transaction.
Financial performance and position
| Metric | 2014 | 2013 |
|---|---|---|
| Net interest income | $115.4 million | $67.7 million |
| Noninterest income | $16.5 million | $9.7 million |
| Provision for loan losses | $4.6 million | $3.7 million |
| Noninterest expense | $99.4 million | $59.5 million |
| Net income | $21.0 million | $9.6 million |
| Diluted earnings per share | $0.82 | $0.61 |
| Net interest margin | 4.53% | 4.80% |
| Efficiency ratio | 75.35% | 76.94% |
| Return on average assets | 0.74% | 0.62% |
- Fourth quarter: Net interest income was $36.8 million, noninterest income $3.9 million, provision expense $2.9 million and net income $7.3 million, compared with $17.6 million, $2.4 million, $0.4 million and $0.7 million, respectively, in fourth quarter 2013. Diluted EPS was $0.24 versus $0.04.
- Balance sheet at year-end: Assets were $3.46 billion, net loans $2.22 billion, investment securities $778.7 million, deposits $2.91 billion and stockholders’ equity $454.5 million. Assets more than doubled from $1.66 billion at year-end 2013, primarily due to the merger.
- Cash flow and liquidity: Operating cash flow was $51.3 million; investing activities used $121.6 million and financing activities provided $61.5 million. Cash and cash equivalents declined $8.8 million to $121.6 million. The bank had $559.3 million of unpledged available-for-sale securities and undrawn credit facilities of $374.3 million at the FHLB and $53.2 million at the Federal Reserve.
- Funding and debt: Deposits were the primary funding source; 81.9% were non-maturity deposits. Year-end liabilities included $19.1 million of junior subordinated debentures and $32.2 million of repurchase agreements. No FHLB advances or federal funds purchased were outstanding.
- Capital and credit: Consolidated total risk-based capital, Tier 1 risk-based capital and leverage ratios were 15.1%, 13.9% and 10.2%; the bank was classified as well capitalized. Noncovered nonperforming loans were $7.5 million, or 0.35% of noncovered loans, versus $7.7 million, or 0.66%, a year earlier. The noncovered allowance was $22.2 million, or 1.04% of those loans.
Material changes versus the prior period
- The Washington Banking merger added substantial loans, deposits, securities, branches and staff, and resulted in issuance of 14.0 million Heritage shares. The merger contributed $10.8 million of purchased-loan discount accretion to 2014 interest income.
- Net income rose $11.4 million year over year, while net interest margin declined 27 basis points. Management attributed the margin pressure mainly to lower contractual loan rates; purchased-loan accretion contributed 0.56 percentage points to the 2014 margin.
- Noninterest expense increased 67% to $99.4 million, including $9.6 million of identified initiative costs, of which $9.1 million related to the Washington Banking merger. Management reported that revenue growth outpaced expense growth and the efficiency ratio improved modestly.
- Noninterest income growth included higher service charges and mortgage loan-sale gains after mortgage banking operations resumed. The FDIC indemnification asset fell to $1.1 million from $4.4 million.
- Noncovered potential problem loans increased to $117.3 million from $52.8 million, primarily due to acquired loans. Covered-loan net charge-offs rose to $3.0 million from $73,000.
Outlook, risks and unusual items
- Management’s strategy emphasizes commercial relationships, deposit growth, asset quality and disciplined expansion. It said it expects the efficiency ratio to continue to decrease as merger cost savings are realized, but provided no numerical earnings or revenue guidance.
- Key risks include commercial and commercial real estate loan concentration, borrower cash-flow and collateral risks, construction lending, regional economic weakness, interest-rate and margin sensitivity, and the adequacy of loan-loss estimates. Management also highlighted acquisition integration, goodwill impairment, liquidity and regulatory/compliance risks.
- The company reported $119.0 million of goodwill and no 2014 impairment. The Washington Banking merger purchase-price allocation remained subject to completion by March 31, 2015.
- The Washington Banking shareholder litigation was settled and dismissed in February 2015; plaintiffs’ counsel received $450,000 in fees and expenses. The company denied wrongdoing.
- After year-end, Heritage sold its legacy merchant card portfolio for $2.2 million. It expects to recognize the consideration in first-quarter 2015 income; $550,000 is contingent on 2015 portfolio performance.
- The board declared a $0.10-per-share dividend in January 2015. A new repurchase authorization permits repurchase of up to approximately 1.513 million shares; no shares were repurchased under that new plan during 2014.
Most important facts for investors to verify
- How much of earnings growth is sustainable after separating merger effects, purchased-loan discount accretion and merger-related costs.
- Whether merger cost savings materialize and improve the efficiency ratio as management expects.
- Credit performance of acquired and noncovered loans, particularly the increase in potential problem loans and covered-loan losses; assess allowance adequacy and FDIC shared-loss coverage and expiration terms.
- Exposure to interest-rate changes, including the effect of funding repricing, securities duration and the decline in net interest margin.
- Capital and liquidity after merger integration, planned lending, dividends and any share repurchases; review the full Basel III capital disclosures.
- Completion and final valuation of the Washington Banking purchase-price allocation, and the realization of the merchant-card sale’s contingent consideration.