Heritage Financial Corporation — Q2 2011 Form 10-Q
Reporting period: Three and six months ended June 30, 2011; balance-sheet comparisons are to December 31, 2010. Amounts are in U.S. dollars; financial statement figures below are in millions unless otherwise noted.
Business context
Heritage Financial is a Washington bank holding company operating Heritage Bank and Central Valley Bank. Its business centers on commercial lending and deposits, with residential, construction, real estate and consumer lending also contributing. Results include the effects of the 2010 Cowlitz Bank and Pierce Commercial Bank acquisitions.
Financial performance
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Interest income | $19.9 | $12.7 | $37.4 | $25.6 |
| Net interest income | $18.2 | $10.8 | $33.8 | $21.4 |
| Provision for loan losses, including purchased loans | $3.5 | $3.2 | $7.9 | $6.9 |
| Non-interest income | $0.9 | $2.1 | $4.3 | $4.2 |
| Non-interest expense | $13.2 | $8.5 | $26.8 | $16.5 |
| Net income | $1.7 | $0.9 | $2.5 | $1.6 |
| Diluted earnings per share | $0.11 | $0.05 | $0.16 | $0.08 |
| Net interest margin | 5.93% | 4.60% | 5.50% | 4.59% |
| Efficiency ratio | 69.3% | 65.7% | 70.4% | 64.2% |
Management attributed higher net interest income and margin primarily to acquired assets and discount accretion on acquired loans. Acquired-loan discount accretion added approximately 1.32 percentage points to loan yield in Q2 and 0.87 points for the first half. Lower deposit funding costs also helped; average interest-bearing liability costs declined year over year.
Financial position, cash flow and credit
- At June 30, total assets were $1.339 billion, down 2.1% from year-end; net loans were $981.6 million, broadly flat, while originated loans grew $40.5 million to $782.5 million.
- Deposits were $1.108 billion, down $28.6 million (2.5%). Certificates of deposit fell $50.0 million; non-maturity deposits rose $21.2 million. Repurchase-agreement funding was $17.3 million, with no other borrowings outstanding.
- Cash and cash equivalents were $117.4 million, or 8.8% of assets. The company reported available, uncommitted credit facilities of $179.7 million at the FHLB, $67.1 million at the Federal Reserve and $22.8 million in other federal-funds lines.
- Six-month operating cash flow was $11.1 million; investing cash flow was negative $31.8 million and financing cash flow negative $30.9 million. Cash and cash equivalents declined $51.6 million to $117.4 million, largely reflecting securities purchases and deposit outflows.
- Stockholders’ equity rose to $205.7 million from $202.3 million; equity was 15.4% of assets. The banks were classified as well capitalized. At the consolidated level, Tier 1 leverage was 14.4% and total risk-based capital was 21.6%.
- Originated nonperforming loans were $29.0 million, or 3.24% of originated loans, versus $26.9 million and 3.19% at year-end. Nonperforming originated assets were $30.9 million. Potential problem originated loans declined to $47.3 million from $56.1 million.
- The originated-loan allowance was $22.0 million, 2.81% of originated loans and 86.9% of nonperforming originated loans. Net charge-offs for the first half were $4.6 million, down from $6.8 million a year earlier. Purchased-loan provisions were $3.3 million in the first half.
Material changes, outlook and risks
- Net income increased year over year, but expense growth outpaced revenue: Q2 non-interest expense rose 55.5%, and first-half expense rose 63.0%, substantially reflecting the Cowlitz and Pierce acquisitions. The efficiency ratio deteriorated accordingly. Management said expenses were expected to move more in line with revenue as growth strategies produced long-term results; the filing provides no numerical earnings guidance.
- Q2 non-interest income included a $1.7 million negative change in the FDIC indemnification asset, contributing to the year-over-year decline in quarterly non-interest income. The asset stood at $14.5 million at quarter-end. Further acquired-loan deterioration could require provisions; covered-loan losses may be partly offset through FDIC loss sharing, subject to the agreement and estimates.
- Management cited credit exposure to commercial real estate and construction, economic and property-market conditions, interest-rate and funding changes, regulatory reviews, expense control, fair-value estimates, acquisition integration, litigation and operational/technology risks. Regulators could require higher loan-loss reserves or otherwise affect capital, liquidity or earnings.
- The filing states that interest-rate risk had not materially changed since year-end 2010. The company reported no trading account or hedging activity. Management found disclosure controls effective and reported no material change in internal control over financial reporting. Pending legal proceedings were not expected to have a material aggregate effect; no material changes to the prior annual report’s risk factors were reported.
- The board declared a $0.05-per-share dividend on July 27, 2011, payable August 26, 2011. Common dividends remain subject to earnings, capital and regulatory constraints.
Important facts for investors to verify
- How much of current net interest income and margin depends on acquisition-related loan discount accretion, and how sustainable those benefits are.
- Whether deposit trends, particularly the decline in certificates of deposit, continue and how liquidity and funding costs respond.
- Credit quality in commercial and construction lending, including nonperforming/restructured loans, potential problem loans, charge-offs and reserve adequacy.
- The trajectory of acquisition-related operating costs and the efficiency ratio, and whether expected revenue benefits materialize.
- Future FDIC indemnification-asset estimates, covered-loan loss reimbursements and any additional purchased-loan provisions.