Heritage Financial Corporation — Q3 2014 Form 10-Q
Business context and period: Unaudited results cover the quarter and nine months ended September 30, 2014. Heritage is a Washington-based bank holding company operating through Heritage Bank, with 67 branches in Washington and the greater Portland, Oregon area. The May 1, 2014 Washington Banking Company merger materially expanded the company; reported 2014 results include the acquired bank only from the merger date, so comparisons with 2013 are not on a like-for-like basis.
Key financial results
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Net interest income | $33.3 million | $17.6 million | $78.6 million | $50.1 million |
| Provision for loan losses | $0.6 million | $1.1 million | $1.7 million | $3.2 million |
| Noninterest income | $5.5 million | $2.6 million | $12.6 million | $7.2 million |
| Noninterest expense | $28.4 million | $14.3 million | $70.1 million | $41.0 million |
| Net income | $7.1 million | $3.3 million | $13.8 million | $8.9 million |
| Diluted EPS | $0.23 | $0.20 | $0.57 | $0.57 |
| Net interest margin | 4.32% | 4.67% | 4.43% | 4.88% |
| Efficiency ratio | 73.1% | 70.9% | 76.9% | 71.6% |
Amounts are as reported; dollars in millions except per-share data and percentages. Management attributed higher income primarily to the merger and lower loan-loss provisions. EPS growth lagged net-income growth in part because the merger substantially increased shares outstanding. Net interest margin and efficiency worsened year over year.
Balance sheet, liquidity, and capital
- At September 30, 2014, total assets were $3.45 billion, up 108% from December 31, 2013, primarily due to the merger. Total loans, net of allowance, were $2.17 billion; deposits were $2.90 billion.
- Cash and cash equivalents totaled $210.2 million, or 6.1% of assets. The company reported $25.3 million of operating cash flow, $14.9 million of net cash used in investing activities, and $69.3 million of financing cash flow for the first nine months.
- Funding included $19.0 million of junior subordinated debentures assumed in the merger and $35.4 million of repurchase agreements. The bank reported no outstanding borrowings on $408.9 million of FHLB facilities, $48.9 million of Federal Reserve facilities, or $68.0 million of correspondent-bank federal-funds lines at quarter-end.
- Stockholders’ equity was $451.7 million, or 13.1% of assets. Heritage Bank’s capital ratios were 10.1% Tier 1 leverage, 14.5% Tier 1 risk-based, and 15.7% total risk-based; management said the bank remained well capitalized.
Material changes and asset quality
- The Washington Banking merger added approximately $1.75 billion of fair-value assets and $1.43 billion of deposits, and generated $89.5 million of goodwill. Purchase accounting allocations were preliminary, with loan and related FDIC-asset valuations still being completed.
- Noncovered nonperforming loans rose to $11.7 million from $7.7 million at year-end, while noncovered nonperforming assets rose to $15.8 million from $12.1 million. Noncovered potential problem loans increased to $125.4 million from $52.8 million; $83.2 million of the September balance was acquired in the merger.
- The noncovered allowance was $22.2 million, 1.08% of noncovered loans, compared with $22.7 million and 1.94% at year-end. The lower ratio primarily reflects acquired loans initially recorded at fair value without an allowance. Noncovered net charge-offs were $1.4 million for the nine-month period, down from $3.0 million.
- Merger-related expenses were $1.3 million in Q3 and $7.4 million year to date. Total noninterest expense rose sharply, and the efficiency ratio increased. Management cited added employees, systems and occupancy costs, professional fees, and integration expenses.
Outlook, commentary, and risks
- Management expects net interest margin to continue declining, citing the low-rate environment and projected principal reduction in higher-yielding purchased loans.
- The company targets cost savings of approximately 10% of combined-company noninterest expense. Savings were not expected to be fully realized until after the core-system conversion, completed in October 2014. Management also expects expanded lending, mortgage banking, SBA activity, and other revenue opportunities; no specific earnings guidance was provided.
- On October 23, 2014, the board authorized a new repurchase plan for up to 5% of outstanding shares, approximately 1.513 million shares, and declared a $0.09-per-share dividend payable November 20, 2014.
- Key disclosed risks include credit deterioration and adequacy of loan-loss reserves; interest-rate and margin sensitivity; integration, retention, and realization of merger synergies; regulatory capital and examination outcomes, including Basel III implementation; valuation and potential impairment of goodwill; competition, operating costs, cybersecurity and third-party systems, and litigation.
- A shareholder class-action lawsuit concerning the Washington Banking merger was subject to a memorandum of understanding for settlement; final settlement documentation and court approval were not assured. The company said it denied the allegations.
- Management reported disclosure controls were effective and no material change in internal control over financial reporting during the period. The filing stated there had been no material change to the risk factors in the 2013 Form 10-K.
Most important facts for investors to verify
- Whether the acquired-loan and FDIC-indemnification valuations are finalized without material adjustments, and whether goodwill remains recoverable.
- How acquired and legacy credit exposures evolve, especially the $125.4 million of potential problem loans, nonperforming loans, and reserve adequacy.
- Whether the company achieves the targeted 10% cost savings after integration, and how remaining merger expenses affect earnings and efficiency.
- Whether margin compression and purchased-loan accretion trends develop as management expects.
- Capital, liquidity, and deposit trends, including regulatory capital effects from Basel III and the implications of the new share-repurchase authorization.
- Final court approval and terms of the proposed shareholder-litigation settlement.