Heritage Financial Corporation — Q2 2020 Form 10-Q
Reporting period: Three and six months ended June 30, 2020; balance-sheet comparisons are to December 31, 2019. Heritage Financial is a Washington bank holding company operating Heritage Bank, with 62 branches in Washington and the greater Portland, Oregon area. The bank focuses primarily on commercial lending and deposits.
Financial performance
| Metric | Q2 2020 | Q2 2019 | Six months 2020 | Six months 2019 |
|---|---|---|---|---|
| Net interest income | $50.3 million | $50.5 million | $98.9 million | $100.3 million |
| Provision for credit losses | $28.6 million | $1.4 million | $36.5 million | $2.3 million |
| Noninterest income | $8.2 million | $7.6 million | $17.7 million | $15.0 million |
| Noninterest expense | $37.1 million | $37.5 million | $74.3 million | $74.1 million |
| Net income (loss) | $(6.1) million | $16.0 million | $6.1 million | $32.5 million |
| Diluted EPS | $(0.17) | $0.43 | $0.17 | $0.88 |
| Net interest margin | 3.64% | 4.33% | 3.84% | 4.34% |
The Q2 net loss chiefly reflected elevated credit-loss provisioning tied to the pandemic and deteriorating economic forecasts. Net interest margin compressed as asset yields fell, including from low-yielding PPP loans, partly offset by lower funding costs. The six-month effective tax rate was 5.1%, versus 16.5% a year earlier; the CARES Act enabled recognition of a $1.0 million tax benefit related to net operating losses from prior acquisitions.
Financial condition, cash flow and capital
- Total assets were $6.56 billion, up 18.2% from year-end 2019. Net loans were $4.59 billion, up 23.1%, including $856.5 million of SBA PPP loans; deposits rose 21.5% to $5.57 billion.
- Cash and cash equivalents were $415.1 million. For the first six months, operating cash flow was $72.3 million, investing cash outflow was $841.6 million, and financing cash inflow was $955.9 million. Deposit growth funded much of the increase in lending.
- At June 30, the allowance for credit losses on loans was $71.5 million, or 1.53% of loans (1.88% excluding PPP loans), versus $36.2 million and 0.96% at year-end. Net charge-offs for the half-year were $2.4 million.
- Nonperforming loans were $33.6 million, or 0.72% of loans, down from $44.5 million and 1.18% at year-end. Potential problem loans increased to $100.6 million from $87.8 million. No loans were 90 days past due and still accruing.
- Stockholders’ equity was $793.7 million, down from $809.3 million; the equity-to-assets ratio declined to 12.1% from 14.6%. The Bank remained classified as well capitalized; its CET1, Tier 1 leverage, Tier 1 risk-based and total risk-based ratios were 11.6%, 10.0%, 11.6% and 12.8%, respectively.
- Borrowings included $20.7 million of junior subordinated debentures and $24.4 million of repurchase agreements. No FHLB or Federal Reserve advances were outstanding; available FHLB and Federal Reserve facilities were $942.8 million and $60.3 million, respectively.
Material changes and notable items
- Adoption of CECL on January 1, 2020 increased the opening allowance on loans by a net $1.8 million and the allowance on unfunded commitments by $3.7 million. The total $7.1 million pretax cumulative adjustment reduced opening retained earnings by $5.6 million after tax. Prior-year figures were not restated.
- The Bank funded 4,498 PPP loans totaling $883.9 million by June 30. These loans earn 1% interest; unamortized net deferred fees were $25.3 million. PPP lending and associated customer deposits materially increased reported loans, assets and deposits.
- COVID-related initial loan modifications totaled $591.5 million across 1,821 loans; 124 loans totaling $122.3 million were downgraded in conjunction with or shortly after modification. A further 24 loans totaling $27.7 million received secondary modifications. These initial modifications were not classified as TDRs under CARES Act guidance.
- The Company suspended stock-plan repurchases during Q2. It repurchased 795,700 shares for $19.1 million during the first half and declared $0.40 per share in dividends. A regular $0.20 dividend was declared July 22, payable August 19, 2020.
Outlook, management commentary and risks
The filing provides no quantified earnings guidance. Management expects net interest income and net interest margin to be adversely affected in the near term, potentially longer, by the pandemic and lower interest rates. Its June CECL forecast assumed a widened “U-shaped” recovery, unemployment peaking at 13% in Q2 2020 and declining to 5% by 2023, and GDP contracting 6.1% in 2020 before rebounding 6.3% in 2021. Management cautioned that further economic deterioration could require additional provisions and adversely affect earnings, capital and liquidity.
Key uncertainties include borrower repayment capacity, the performance of modified loans, losses in vulnerable industries, the adequacy of the allowance, interest-rate sensitivity, operational and cybersecurity risks from remote work, and possible restrictions on Bank dividends to the holding company. The Company reported no material pending legal proceedings beyond routine litigation. It performed a COVID-triggered goodwill assessment and concluded fair value more likely than not exceeded carrying value, while warning future adverse conditions could cause impairment.
Important facts for investors to verify
- Whether pandemic-related borrower stress, especially among modified loans and hospitality exposures, leads to additional downgrades, delinquencies, charge-offs or allowance increases.
- How much of loan and deposit growth is attributable to PPP activity, and the timing and effect of PPP forgiveness and fee recognition.
- Whether net interest margin stabilizes as deposit pricing adjusts and short-term rates remain low.
- Whether the $71.5 million loan allowance and $4.6 million unfunded-commitment allowance remain adequate as economic forecasts and actual credit performance evolve.
- Capital, liquidity and dividend capacity if earnings weaken or the Bank’s ability to upstream dividends is constrained; also monitor the decline in the equity-to-assets ratio.