Heritage Financial Corporation — Q1 2020 Form 10-Q
Business context and reporting period
Unaudited results for the three months ended March 31, 2020, compared with Q1 2019. Heritage Financial is a Washington bank holding company operating Heritage Bank, with 62 branches in Washington and the greater Portland, Oregon area. Its business centers on commercial lending and deposits, with residential mortgage, construction, land development and consumer lending also offered.
Key financial metrics
| Metric | Q1 2020 / March 31, 2020 | Comparable / prior date |
|---|---|---|
| Net income; diluted EPS | $12.2 million; $0.33 | Q1 2019: $16.6 million; $0.45 |
| Net interest income | $48.6 million | Q1 2019: $49.8 million |
| Net interest margin | 4.06% | Q1 2019: 4.34% |
| Provision for credit losses, net | $7.9 million | Q1 2019: $0.9 million |
| Noninterest income / expense | $9.5 million / $37.3 million | Q1 2019: $7.4 million / $36.5 million |
| Total assets | $5.59 billion | December 31, 2019: $5.55 billion |
| Loans receivable, net | $3.80 billion | December 31, 2019: $3.73 billion |
| Deposits | $4.62 billion | December 31, 2019: $4.58 billion |
| Cash and cash equivalents | $162.9 million | December 31, 2019: $228.6 million |
| Stockholders’ equity | $798.4 million; 14.3% of assets | December 31, 2019: $809.3 million; 14.6% |
| Nonperforming assets | $35.0 million; 0.63% of assets | December 31, 2019: $45.4 million; 0.82% |
Operating cash flow was $16.1 million, investing cash flow was negative $82.3 million, and financing cash flow was positive $0.6 million. Net cash decreased $65.7 million during the quarter. The efficiency ratio was 64.20%, versus 63.84% in Q1 2019. The Bank reported regulatory capital ratios above minimum requirements and remained categorized as well capitalized; its total risk-based capital ratio was 12.4%.
Material changes versus the prior comparable period
- Net income fell 26.3%, principally reflecting the larger credit-loss provision following adoption of CECL and management’s assessment of pandemic-related risk.
- The loan allowance rose to $47.5 million, or 1.23% of loans, from $36.2 million, or 0.96%, at year-end. The quarter’s $10.0 million loan provision included approximately $6.9 million attributed to the economic forecast and COVID-19-related qualitative factors. A $2.0 million reversal for unfunded commitments reduced the total reported provision to $7.9 million.
- Net interest margin contracted 28 basis points as asset yields fell and funding costs rose. Net interest income declined 2.5% despite average interest-earning asset growth of 3.5%.
- Noninterest income increased 27.6%, helped by securities-sale gains, mortgage loan-sale gains, swap fees and a BOLI death benefit. Noninterest expense rose 2.0%.
- Loans grew 2.0% from year-end, while deposits rose 0.8%. Nonaccrual loans declined to $34.2 million, but potential problem loans increased to $102.2 million from $87.8 million.
Outlook, management commentary, risks and unusual items
- No quantitative earnings guidance was provided. Management expected COVID-19 and sharp Federal Reserve rate cuts to weigh on net interest income and margin in the near term, potentially longer. The filing’s CECL forecast assumed a severe but temporary downturn and recovery toward year-end; management stressed substantial uncertainty around that outlook.
- The Bank offered short-term relief to borrowers. By March 31, it had modified 134 commercial business loans totaling $77.5 million, two construction and land-development loans totaling $2.1 million, and 27 consumer loans totaling $0.8 million. Additional modifications were made in April. These relief modifications were not classified as TDRs under CARES Act guidance.
- After quarter-end, the Bank began PPP lending. As of May 3, 2020, it had funded 3,386 loans totaling $785.0 million and received SBA approval for another 784 loans totaling $86.1 million. The filing says PPP liquidity was initially drawn from cash reserves, with a transition to the Federal Reserve’s PPPLF expected as funds were used.
- CECL adoption on January 1 reduced beginning retained earnings by $5.6 million after tax, including a $3.7 million increase in the unfunded-commitment allowance. The accounting change limits direct comparability with prior-period credit-loss figures.
- The company repurchased $19.1 million of common stock during the quarter, then halted buybacks in March pending greater clarity on the pandemic’s effect on long-term capital. The board declared a regular $0.20-per-share dividend in April.
- Key risks include deterioration in borrower repayment capacity, further allowance increases, lower rates and margin pressure, operational and cybersecurity disruption, uncertainty in borrower relief outcomes, and limits on the Bank’s ability to pay dividends to the holding company. Management reported no material pending legal proceedings and concluded disclosure controls were effective.
Important facts for investors to verify
- How subsequent borrower payment performance, delinquencies, criticized loans and charge-offs compare with the March 31 credit-loss assumptions.
- Whether the $47.5 million loan allowance and $2.0 million unfunded-commitment allowance remain adequate as economic forecasts and loan modifications evolve.
- PPP funding, SBA forgiveness and reimbursement mechanics, PPPLF usage, and the resulting effects on liquidity, loan balances and fee income.
- Deposit composition and funding costs, and whether net interest margin continues to face pressure from low market rates.
- Capital, liquidity and dividend capacity if credit losses rise; the Bank reported $898.5 million of FHLB and $74.0 million of Federal Reserve borrowing capacity, with no advances outstanding at quarter-end.