Heritage Financial Corporation — FY 2018 Form 10-K
Reporting period: Year ended December 31, 2018; filed March 1, 2019. The company is a Washington bank holding company operating Heritage Bank, with 64 branches in Washington and Oregon and a primarily commercial-banking focus. Annual results include Puget Sound Bancorp from January 16, 2018 and Premier Commercial Bancorp from July 2, 2018.
Financial performance and position
| Metric | 2018 | 2017 | Change / context |
|---|---|---|---|
| Net interest income | $186.9 million | $139.4 million | Up 34.1%, largely reflecting acquisitions, asset growth and higher yields |
| Net income | $53.1 million | $41.8 million | Up 27.0% |
| Diluted earnings per share | $1.49 | $1.39 | Up from prior year |
| Net interest margin | 4.29% | 3.93% | Up 36 basis points; 4.11% excluding purchased-loan discount accretion |
| Noninterest income | $31.7 million | $35.6 million | Down 11.0%, mainly lower loan-sale gains |
| Noninterest expense | $149.4 million | $110.6 million | Up 35.1%; includes $10.4 million of merger-related expenses |
| Efficiency ratio | 68.34% | 63.21% | Worsened, primarily due to acquisition expenses and integration costs |
| Total assets | $5.32 billion | $4.11 billion | Up 29.3% |
| Loans receivable, net | $3.62 billion | $2.82 billion | Up 28.5%; acquired loans contributed substantially |
| Deposits | $4.43 billion | $3.39 billion | Up 30.6%; non-maturity deposits were 89.5% of total |
| Cash and cash equivalents | $161.9 million | $103.0 million | Up $58.9 million |
| Shareholders’ equity | $760.7 million | $508.3 million | Includes $230.0 million of stock issued in the acquisitions |
- Cash flow: Operating activities provided $82.4 million; investing activities used $101.6 million; financing activities provided $78.1 million. Cash increased $58.9 million during the year.
- Credit quality: Nonperforming loans were $13.7 million, or 0.37% of net loans, versus $10.7 million, or 0.38%, a year earlier. The allowance for loan losses was $35.0 million, 0.96% of loans and 255.73% of nonperforming loans. Net charge-offs were $2.2 million; provision expense was $5.1 million.
- Debt and liquidity: No FHLB advances were outstanding at year-end, compared with $92.5 million in 2017. The company had $20.3 million of junior subordinated debentures and $31.5 million of repurchase-agreement funding. Available FHLB capacity was $921.7 million; cash and unpledged available-for-sale securities were $161.9 million and $711.4 million, respectively.
- Capital: Consolidated CET1, Tier 1 risk-based, total risk-based and leverage ratios were 11.7%, 12.1%, 12.9% and 10.5%, respectively. The Bank met the regulatory “well-capitalized” thresholds.
- Returns and distributions: Return on average assets was 1.07%; return on average common equity was 7.72%. Dividends declared were $0.72 per share for 2018; a $0.18 quarterly dividend was declared in January 2019.
Material changes versus the prior year
- The Puget Sound and Premier acquisitions added approximately $957.6 million in assets, $718.6 million in loans and $824.6 million in deposits at their respective closing dates. They generated $121.9 million of goodwill and $18.3 million of core deposit intangibles.
- Net interest income rose with acquired balances and higher asset yields. Average loan yield increased to 5.14% from 4.78%; purchased-loan accretion contributed $8.0 million to interest income in 2018 and is expected to decline as acquired loans run off.
- Interest expense increased 48.7% to $12.4 million as funding costs and interest-bearing deposits rose. The average cost of interest-bearing liabilities increased to 0.42% from 0.33%.
- Loan-sale gains fell to $2.8 million from $7.7 million, partly because 2017 included a $3.0 million gain on a purchased credit-impaired loan. Mortgage-loan sale volume also declined.
- The effective tax rate fell to 17.2% from 30.5%, primarily reflecting the reduction in the federal corporate tax rate to 21%. The 2017 comparison included a $2.6 million tax expense from revaluing deferred tax balances.
- Nonperforming assets rose to $15.7 million from $10.7 million, while potential problem loans increased to $101.3 million from $83.5 million. Management attributed the increase in nonperforming commercial loans partly to several commercial and industrial relationships.
Outlook, commentary, risks and unusual items
- No formal earnings or revenue guidance is provided. Management described a strategy of disciplined Pacific Northwest growth, commercial relationship banking, deposit growth and close credit oversight, while seeking acquisition integration benefits and cost efficiencies.
- Interest-rate sensitivity modeling estimated that a 100-basis-point increase would raise net interest income by $8.0 million in year one and $14.3 million in year two; a 200-basis-point increase would raise it by $16.1 million and $28.7 million. A 100-basis-point decrease was modeled to reduce it by $8.3 million and $14.7 million. These are estimates subject to model assumptions, not guidance.
- Key risks include commercial real estate and commercial-business credit concentrations, economic weakness in Washington and Oregon, higher deposit costs in a rising-rate environment, acquisition integration and goodwill impairment, liquidity and funding access, cybersecurity and third-party service disruptions, and regulatory or legal changes.
- The company expects to adopt CECL on January 1, 2020. It was evaluating the financial and capital impact and had not determined the size of any initial allowance adjustment.
- Other notable items: $1.7 million was spent to buy out a third-party contract, with management expecting future savings to offset the cost by the end of 2019; sale of a branch and former administrative building generated $798,000 in gains. The annual goodwill test found no impairment.
- CEO Brian Vance announced plans to retire July 1, 2019 and become Executive Board Chair. The auditor issued an unqualified opinion and concluded internal control over financial reporting was effective; the acquired Puget Sound and Premier operations were excluded from the internal-control assessment and audit scope.
Important facts for investors to verify
- How much of 2018’s earnings and margin improvement is sustainable after acquired-loan accretion, merger costs and tax-rate changes?
- Whether integration delivers the anticipated efficiencies, and whether customer or employee attrition, further costs or goodwill impairment emerge.
- Trends in nonperforming and potential problem loans, especially commercial and industrial and commercial real estate exposures, and whether the allowance remains adequate.
- Deposit pricing, deposit retention and net interest margin as rates and competition change; compare actual results with the filing’s modeled rate sensitivities.
- The eventual CECL allowance and regulatory-capital impact, and the progress of implementation ahead of the 2020 adoption date.