Heritage Financial Corporation — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018; balance-sheet comparisons are with December 31, 2017. Heritage is a Washington-based bank holding company operating through Heritage Bank, with commercial banking markets in Washington and the greater Portland, Oregon area. The quarter includes Puget Sound Bancorp results from its January 16, 2018 acquisition.
Financial results and position
- Revenue and earnings: Interest income was $43.3 million, up 24.3% year over year; noninterest income was $7.5 million, up 1.6%. Their combined total was $50.8 million, compared with $42.2 million in Q1 2017. Net income was $9.1 million, down 2.5%; diluted EPS was $0.27 versus $0.31.
- Net interest income and margins: Net interest income rose 23.4% to $40.9 million. Net interest margin increased 23 basis points to 4.12%; net interest spread was 4.02%. Management attributed the margin and income gains to growth in earning assets, higher asset yields, and the acquisition.
- Expenses and taxes: Noninterest expense increased 35.0% to $36.7 million, including approximately $4.7 million of acquisition-related costs for Puget Sound and the proposed Premier transaction. The efficiency ratio rose to 75.95% from 67.23%. Income tax expense declined to $1.4 million; the effective tax rate was 13.3%, primarily reflecting the federal tax-rate reduction.
- Cash flow: Operating activities provided $9.1 million; investing activities provided $86.4 million, including $80.1 million of net cash from acquisitions; financing activities used $68.3 million, primarily reflecting $61.8 million of net FHLB repayments. Cash and cash equivalents ended at $130.3 million.
- Assets, loans, and deposits: Total assets were $4.68 billion, up 13.7% from year-end. Net loans were $3.25 billion, up 15.3%, primarily due to Puget Sound. Deposits were $3.90 billion, up 15.1%; the acquired bank contributed $505.9 million of deposits. Non-maturity deposits were 89.2% of deposits.
- Debt and liquidity: At quarter-end, FHLB advances were $30.7 million, junior subordinated debentures were $20.1 million, and repurchase agreements were $26.1 million. The Bank reported FHLB and Federal Reserve facilities of $913.0 million and $81.4 million, respectively, and $90.0 million of federal-funds lines; no federal funds were drawn. Cash was $130.3 million, and $559.0 million of available-for-sale securities were unpledged.
- Capital: Stockholders’ equity was $634.7 million, or 13.6% of assets. Heritage Bank was reported as well capitalized; its total risk-based capital ratio was 12.3% and leverage ratio was 10.0%.
Material changes versus comparable periods
- Puget Sound Bancorp’s acquisition expanded the balance sheet and added 4.1 million Heritage shares; the company recorded $68.5 million of goodwill and $11.3 million of acquired intangible assets. Acquired assets included $388.5 million of loans and $505.9 million of deposits.
- Despite higher net interest income, net income fell as expenses rose materially. The filing attributes much of the expense increase to acquisition activity and integration-related costs.
- Credit indicators weakened from year-end: nonaccrual loans increased to $15.7 million from $10.7 million; nonperforming assets rose to 0.34% of assets from 0.26%. Potential problem loans reached $93.3 million from $83.5 million. The allowance for loan losses was $33.3 million, or 1.01% of net loans, compared with $32.1 million, or 1.13%, at year-end.
- Accumulated other comprehensive loss widened to $9.0 million from $1.3 million, mainly reflecting unrealized losses on available-for-sale securities that management attributed primarily to higher market interest rates. The company reported no other-than-temporary impairment charges.
Outlook, risks, and unusual items
- No quantitative earnings or operating guidance is provided. Management states that Q1 results are not necessarily indicative of full-year results.
- Heritage agreed to acquire Premier Commercial Bancorp for 0.4863 Heritage shares per Premier share, valued at approximately $88.6 million based on Heritage’s March 8 closing price. The deal was subject to regulatory and shareholder approvals and was expected to close in Q3 2018; the value could change with Heritage’s share price.
- Management cites integration, customer and employee retention, deal execution, loan quality, economic conditions, interest rates and funding costs, regulation, competition, cybersecurity, and operating-cost control among the risks that could affect future results. It cautions that acquired-loan accretion can vary and noted that about $316,000 of Q1 Puget Sound accretion came from unanticipated payoffs of three significant loans and was not expected to recur at the same level.
- The company says interest-rate risk exposure had not materially changed from its 2017 year-end disclosure. It reported no material changes to risk factors, no material pending legal proceedings beyond routine litigation, and effective disclosure controls as of March 31, 2018.
- Heritage adopted revenue-recognition guidance with no material financial-statement impact. It expected the 2019 lease standard to increase reported assets and liabilities; the filing reported $13.9 million of minimum noncancelable operating-lease payments.
Important facts for investors to verify
- Whether the Puget Sound integration delivers expected cost savings and revenue benefits, and how acquisition costs and purchase-accounting accretion affect earnings in subsequent quarters.
- Premier transaction approvals, timing, final consideration, and integration costs.
- Trends in nonaccrual and potential problem loans, charge-offs, allowance adequacy, and the acquired loan portfolio’s performance.
- Deposit pricing, funding costs, loan yields, and net interest margin as market rates change.
- Whether earnings and operating efficiency improve as acquisition-related expenses subside, and the continuing impact of unrealized securities losses on equity.