Heritage Financial Corporation — Q3 2020 Form 10-Q
Business context and reporting period
Heritage Financial Corporation is a Washington bank holding company whose subsidiary, Heritage Bank, operates in Washington and the greater Portland, Oregon area. The filing covers the quarter and nine months ended September 30, 2020; financial statements are unaudited. The Bank focuses primarily on commercial lending and deposits. It originated SBA Paycheck Protection Program (PPP) loans during 2020.
Financial performance and condition
| Metric | Q3 2020 / September 30, 2020 | Comparison |
|---|---|---|
| Net income | $16.6 million; diluted EPS $0.46 | Q3 2019: $17.9 million; diluted EPS $0.48 |
| Net interest income | $49.7 million | Q3 2019: $50.2 million |
| Net interest margin | 3.38% | Q3 2019: 4.21% |
| Provision for credit losses | $2.7 million | Q3 2019: $0.5 million |
| Noninterest income / expense | $8.2 million / $36.0 million | Q3 2019: $8.5 million / $36.7 million |
| Total assets | $6.69 billion | December 31, 2019: $5.55 billion |
| Loans, net of allowance | $4.59 billion | December 31, 2019: $3.73 billion |
| Deposits | $5.69 billion | December 31, 2019: $4.58 billion |
| Cash and cash equivalents | $576.2 million | December 31, 2019: $228.6 million |
| Stockholders’ equity | $803.1 million; equity/assets 12.0% | December 31, 2019: $809.3 million; 14.6% |
For the first nine months, net income was $22.7 million ($0.63 diluted EPS), down 55.0% from $50.4 million ($1.36) in 2019. Net interest income was $148.5 million versus $150.6 million; net interest margin was 3.67% versus 4.29%. The nine-month provision for credit losses was $39.2 million, compared with $2.8 million in 2019. The effective tax rate was 8.8% versus 16.6%, including a $1.0 million tax benefit related to prior-acquisition net operating losses under the CARES Act.
For the first nine months, operating cash flow was $76.6 million, investing cash flow was negative $803.5 million, and financing cash flow was positive $1.07 billion. Financing inflows primarily reflected a $1.11 billion increase in deposits. No FHLB or Federal Reserve advances were outstanding at quarter-end; the Bank had $891.7 million of FHLB borrowing capacity, $55.0 million of Federal Reserve capacity and $215.0 million of correspondent-bank federal funds lines. Securities repurchase obligations were $29.0 million and junior subordinated debentures were $20.8 million.
The allowance for credit losses on loans was $73.3 million, or 1.57% of loans (1.93% excluding PPP loans), versus $36.2 million, or 0.96%, at year-end 2019. Nonperforming loans were $52.6 million, 1.13% of loans; potential problem loans were $159.8 million, up from $87.8 million. The Bank reported regulatory capital ratios above minimum requirements and remained categorized as well capitalized.
Material changes versus prior periods
- Q3 net income declined 7.0%; nine-month earnings fell 55.0%, principally reflecting the higher credit-loss provision associated with the pandemic and CECL accounting.
- Assets rose 20.4% from year-end, with net loans up 23.1%. PPP loans totaled $867.8 million at September 30; the Bank had funded 4,642 PPP loans totaling $897.4 million during the program.
- Deposits increased 24.1%, driven by PPP proceeds, elevated customer balances and new accounts. Non-maturity deposits rose to 92.2% of deposits from 88.6%.
- The margin contracted as lower market rates and the mix of assets—including low-yield PPP loans and higher interest-earning cash—reduced asset yields. Lower funding costs partly offset this pressure.
- The Company adopted CECL on January 1, 2020. Its cumulative-effect adjustment reduced beginning retained earnings by $5.6 million, net of tax, and established an additional reserve for unfunded commitments.
Outlook, management commentary, risks and unusual items
The filing provides no formal earnings or financial guidance. Management expected net interest income and margin to remain adversely affected in the near term, potentially longer, due to the pandemic and low interest rates. Its September CECL forecast assumed a slow recovery through 2021, with GDP contracting 3.7% in 2020 and rebounding 3.7% in 2021; unemployment was forecast to average 8.7% for the remainder of 2020 and decline gradually to 4.0% by 2025. These are model assumptions, not company guidance.
At September 30, 260 loans totaling $117.1 million remained in active COVID-related payment modification status; $94.5 million were on second deferrals, and $17.2 million of these loans were nonaccrual. The Bank reported $636.9 million of loans modified during the first nine months. It cautioned that borrowers may be unable to resume full payments, and that further economic deterioration could increase delinquencies, charge-offs and provisions. PPP forgiveness processing was expected to begin in Q4 2020; forgiveness timing, servicing demands and evolving SBA rules pose execution risks. PPP loans are fully SBA-guaranteed and excluded from the loan allowance.
Other notable items include suspension of share repurchases in Q3 due to COVID-19, while the quarterly dividend was maintained at $0.20 per share and another $0.20 dividend was declared in October. The Company announced a plan to consolidate nine branches, reducing the network from 62 to 53. Management found goodwill unimpaired at September 30 but warned that future adverse conditions could trigger impairment. COVID-19, borrower credit deterioration, interest-rate movements, deposit behavior, regulatory actions, cybersecurity and third-party service continuity remain material risks. No material pending legal proceedings were reported.
Most important facts for investors to verify
- Whether pandemic-related borrower stress leads to further downgrades, nonaccrual loans, charge-offs or additional reserve building; monitor the $159.8 million of potential problem loans and active deferrals.
- PPP loan forgiveness pace, unamortized deferred fees ($22.0 million), remaining balances and the resulting effects on loan yields, deposits and liquidity.
- Whether net interest margin stabilizes as PPP balances run off and low-rate conditions continue.
- Changes in deposit concentrations and composition, and the Bank’s liquidity and capital position as pandemic-related balances evolve.
- Execution and costs of the nine-branch consolidation, and any changes to dividends or the paused repurchase program.