Heritage Financial Corporation — Q1 2023 Form 10-Q
Business and period. The bank holding company operates Heritage Bank, serving small and midsized businesses and consumers through 51 branches in Washington, Oregon and Idaho. This unaudited report covers the three months ended March 31, 2023; comparisons are with Q1 2022 for results and December 31, 2022 for balance-sheet changes. Figures below are in U.S. dollars.
Financial performance and condition
- Earnings: Net income was $20.5 million, up 3.5% year over year; diluted EPS was $0.58 versus $0.56. Pretax income was $24.7 million and the effective tax rate was 17.1%.
- Revenue and margins: Net interest income rose 27.5% to $59.8 million. Net interest margin increased to 3.91% from 2.84%; the average yield on interest-earning assets rose to 4.35% from 2.94%, while the average cost of interest-bearing liabilities rose to 0.69% from 0.16%. Noninterest income declined 3.3% to $8.3 million. The efficiency ratio improved to 61.1% from 64.4%.
- Costs and credit provision: Noninterest expense increased 16.5% to $41.6 million, including compensation expense up $4.3 million. The provision for credit losses was $1.8 million, compared with a $3.6 million reversal in Q1 2022. The loan allowance was $44.5 million, or 1.08% of loans, versus $43.0 million, or 1.06%, at year-end.
- Cash flow: Operating activities provided $23.4 million; investing activities used $55.0 million; financing activities provided $229.5 million. Cash and cash equivalents ended the quarter at $301.5 million, up $197.9 million from year-end.
- Balance sheet and funding: Total assets were $7.24 billion, up 3.7% from year-end. Loans, net of allowance, were $4.08 billion, up $75.1 million; total deposits were $5.79 billion, down $135.8 million, or 2.3%. The Bank had $383.1 million of overnight FHLB advances outstanding, compared with none at year-end, and $39.2 million in repurchase agreements.
- Liquidity and capital: Reported total available liquidity was $3.47 billion, with $3.09 billion net availability after outstanding FHLB advances. This included $301.5 million of cash, $1.12 billion of unencumbered available-for-sale securities and borrowing capacity. The company’s equity-to-assets ratio was 11.4%; its common equity Tier 1 ratio was 12.9%, and the Bank’s was 13.0%. Management stated both Company and Bank met applicable capital requirements and the Bank was well-capitalized.
- Securities and equity: Total investment securities were $2.08 billion. Available-for-sale securities had $107.2 million of gross unrealized losses; held-to-maturity securities had $75.5 million of unrecognized losses. Stockholders’ equity increased to $826.1 million, partly reflecting $17.1 million of other comprehensive income as securities fair values improved.
Material changes and unusual items
- Higher market rates drove higher asset yields and interest income, but deposit interest expense rose to $4.5 million from $1.4 million, and total interest expense increased to $6.8 million from $1.7 million.
- Deposit balances fell amid competitive pricing and customers moving excess funds to higher-yielding alternatives. Certificates of deposit increased 28.9%, including $52.3 million of brokered deposits, equal to 0.90% of total deposits at quarter-end.
- Commercial and multifamily construction loans grew 26.4% from year-end to $270.5 million. Commercial business loans represented 78.4% of the portfolio; owner-occupied and non-owner-occupied CRE loans totaled approximately $2.55 billion. Office loans were $582.5 million.
- Nonaccrual loans declined to $4.8 million from $5.9 million at year-end, while loans 90 days or more past due and still accruing rose to $2.3 million from $1.6 million. Net charge-offs were $230,000.
- Other income included a $1.6 million gain on the sale of Visa Class B shares. The Company also recorded a $286,000 net loss on available-for-sale securities sales. Q1 2022 noninterest income had included a bank-owned life insurance death benefit.
Outlook, commentary and risks
The filing provides no specific earnings or financial guidance. Management said the effects of continued inflation and Federal Reserve tightening are uncertain. It identified potential pressure on loan demand, credit quality, the allowance for credit losses, securities values and accumulated other comprehensive income, deposit retention and costs, and liquidity. Management noted that deposit costs could continue to rise and said it may use additional FHLB borrowings or brokered deposits to enhance liquidity. Its credit-loss estimates incorporate assumptions about higher rates, inflation, energy prices, economic uncertainty and possible recessionary conditions.
At March 31, modeled parallel rate increases of 100 and 200 basis points indicated first-year net interest income gains of 0.9% and 1.0%, respectively; modeled decreases of 100 and 200 basis points indicated declines of 0.8% and 3.3%. The filing cautions that such simulations rely on uncertain assumptions and actual results may differ. The planned sale of the Ellensburg branch, including approximately $17.2 million of deposits classified as held for sale, was expected to close in Q2 2023, subject to factors including regulatory approval. Management reported effective disclosure controls and no material change in internal control over financial reporting. No material change to previously disclosed risk factors or material pending legal proceedings was reported.
Investor verification priorities
- Track deposit flows, deposit pricing and mix, brokered deposit use, and reliance on overnight FHLB advances against available liquidity.
- Monitor CRE and construction loan growth and concentration, office exposure, criticized loans, delinquencies, nonaccrual balances and allowance adequacy.
- Assess whether net interest margin gains persist as funding costs reprice and interest rates change; compare subsequent results with the filing’s rate-sensitivity scenarios.
- Review securities valuation changes and their effects on equity, including the substantial unrealized losses disclosed for available-for-sale and held-to-maturity portfolios.
- Confirm whether the Ellensburg branch sale closed as expected and evaluate subsequent earnings without the one-time Visa share gain.