Heritage Financial Corporation — FY 2013 Form 10-K
Reporting period: Fiscal year ended December 31, 2013. The filing is an annual report, not a standalone fourth-quarter filing; quarterly figures are provided below where relevant. Heritage is a Washington-based bank holding company operating Heritage Bank, focused mainly on commercial lending and deposits in Washington and the greater Portland, Oregon area.
Financial results and condition
| Metric | FY 2013 / Dec. 31, 2013 | FY 2012 / Dec. 31, 2012 |
|---|---|---|
| Interest income | $71.4 million | $69.1 million |
| Net interest income | $67.7 million | $64.6 million |
| Net interest margin | 4.80% | 5.17% |
| Noninterest income | $9.7 million | $7.3 million |
| Provision for loan losses | $3.7 million | $2.0 million |
| Noninterest expense | $59.5 million | $50.4 million |
| Net income / diluted EPS | $9.6 million / $0.61 | $13.3 million / $0.87 |
| Operating cash flow | $30.9 million | $27.9 million |
| Total assets | $1.66 billion | $1.35 billion |
| Loans, net | $1.20 billion | $998.3 million |
| Deposits | $1.40 billion | $1.12 billion |
| Stockholders’ equity | $215.8 million | $198.9 million |
Margins and operating efficiency: Net interest spread was 4.69%, down from 5.03%. The efficiency ratio rose to 76.9% from 70.1%, reflecting increased operating and integration costs.
Credit quality: Originated nonperforming loans fell to $6.9 million, or 0.53% of originated loans, from $12.5 million, or 1.28%. Net charge-offs on originated loans were $2.9 million, down from $3.9 million. The originated-loan allowance was $17.2 million, equal to 1.76% of originated loans and 329.4% of nonperforming originated loans (excluding government guarantees). Potential problem originated loans increased to $34.5 million from $28.3 million.
Liquidity, funding and capital: Cash and cash equivalents were $130.4 million, or 7.9% of assets. Non-maturity deposits were $1.09 billion, 77.9% of deposits. The company had $29.4 million of securities sold under repurchase agreements, but no FHLB advances, Federal Reserve borrowings or federal funds purchased at year-end. Available credit facilities included $283.6 million from the FHLB, $56.7 million from the Federal Reserve and $50.0 million in federal-funds lines. Consolidated total risk-based capital, Tier 1 risk-based capital and leverage ratios were 16.8%, 15.5% and 11.3%, respectively; the Bank was classified as well capitalized.
Cash flows: Net cash provided by operating activities was $30.9 million; investing activities used $16.6 million; financing activities provided $11.8 million. Cash and cash equivalents increased $26.1 million during the year.
Fourth-quarter results: Net income was $710,000, or $0.04 per diluted share, compared with $3.0 million, or $0.20 per diluted share, in Q4 2012. Q4 2013 noninterest expense was $18.5 million, versus $12.4 million a year earlier, contributing to the lower quarterly earnings.
Material changes versus the prior year
- Assets grew 23.3%, loans net grew 20.5%, and deposits grew 25.2%, primarily reflecting the Northwest Commercial Bank (NCB) and Valley acquisitions, alongside organic loan growth.
- Net interest income increased 4.8%, but margin declined 37 basis points to 4.80%, mainly as loan yields fell in the low-rate environment. Purchased-loan discount accretion contributed about 48 basis points to FY 2013 margin.
- Net income declined 27.8%. The $9.1 million increase in noninterest expense and $1.7 million higher loan-loss provision more than offset higher interest and noninterest income and lower interest expense.
- Noninterest expense included $5.1 million of identified initiative costs, including acquisition and conversion expenses, branch consolidation, the core-system conversion and costs related to the proposed Washington Banking merger.
- Non-maturity deposits increased $260.7 million, primarily through acquisitions, and rose to 77.9% of deposits from 74.2%.
- Heritage completed the NCB acquisition in January and Valley acquisition in July 2013, merged Central Valley Bank into Heritage Bank, and consolidated several branches. It stopped selling residential mortgage loans in the secondary market in Q2 2013 and thereafter retained originations in its portfolio.
Outlook, commentary and risks
Management reported no quantified earnings guidance. It said expenses may remain elevated while growth initiatives are being implemented and expects expense levels to become more aligned with income as those initiatives produce longer-term results. The company’s strategy emphasizes controlled growth, acquisitions, commercial relationships, deposit growth and asset quality.
- A merger with Washington Banking Company and Whidbey Island Bank was expected to close in the first half of 2014, subject to shareholder and regulatory approvals and other closing conditions. The consideration was 0.89 Heritage shares plus $2.75 cash per Washington Banking share; the filing estimated aggregate value of approximately $276.8 million using a stated December 2013 share price. Certain regulatory approvals had been received by the filing date.
- Shareholder litigation sought to block the proposed merger, alleging fiduciary-duty and disclosure issues. Heritage said the aiding-and-abetting claim against it lacked merit; motions to dismiss had been filed.
- Credit risks include the concentration in commercial business lending (86.9% of originated loans) and exposure to commercial real estate, borrower cash flows and property values. Management cautioned that weaker economic conditions could increase delinquencies, charge-offs and provisions.
- Interest-rate changes could pressure earnings: management noted that a positive 0–3 month repricing gap may make results vulnerable to falling rates. The filing also highlights funding, acquisition integration, regulatory, technology and goodwill-impairment risks.
- Basel III requirements were scheduled to begin in 2015, with certain capital-conservation-buffer provisions phased in through 2019. The company was evaluating the expected impact.
Most important facts for investors to verify
- Whether the NCB and Valley integrations, core-system conversion and branch consolidations deliver the anticipated cost savings, and whether the elevated efficiency ratio improves.
- Loan quality across both originated and acquired portfolios, especially the increase in potential problem loans, restructured credits and purchased-loan provisions.
- How much FY 2013 earnings depended on acquired-loan discount accretion and other acquisition-related or nonrecurring items, including the $399,000 NCB bargain-purchase gain and $596,000 branch-sale gain.
- Completion terms and financial effects of the Washington Banking merger, including litigation, integration costs, regulatory conditions and expected dilution.
- Capital and liquidity capacity under Basel III, the effect of interest-rate changes on margin, and the sustainability of dividends and share repurchases.