Heritage Financial Corporation — Q2 2017 Form 10-Q
Business context and reporting period
Heritage Financial is a Washington bank holding company operating Heritage Bank, with 59 branches in Washington and the greater Portland, Oregon area. Its business focuses on commercial lending and deposits, with additional residential mortgage, construction, land development and consumer lending. This unaudited filing covers the quarter and six months ended June 30, 2017; balance-sheet comparisons are against December 31, 2016. Amounts below are in U.S. dollars.
Financial performance and condition
- Q2 earnings: Net income was $11.8 million, up 33.0% from $8.9 million in Q2 2016; diluted EPS was $0.39 versus $0.30. For the first six months, net income was $21.1 million, up 17.6%, and diluted EPS was $0.70 versus $0.60.
- Income and margins: Q2 net interest income rose 3.3% to $34.2 million; noninterest income increased 62.2% to $10.7 million. First-half net interest income was $67.3 million, up 2.2%, and noninterest income was $18.0 million, up 32.8%. Net interest margin declined to 3.92% from 4.00% in Q2 and to 3.91% from 4.02% for the first half. The efficiency ratio improved to 62.0% from 66.8% in Q2 and to 64.5% from 66.5% year to date.
- Expenses and credit costs: Noninterest expense rose 5.0% to $27.8 million in Q2 and 4.1% to $55.0 million in the first half. Loan-loss provision was $1.1 million in Q2, broadly unchanged year over year, and $2.0 million for the first half, down from $2.3 million.
- Cash flow: For the first six months, operating activities provided $44.0 million, investing activities used $107.5 million and financing activities provided $84.0 million. Cash and cash equivalents increased $20.5 million to $124.2 million.
- Balance sheet and funding: Total assets increased 2.9% to $3.99 billion. Loans receivable, net of allowance, were $2.72 billion, up 4.1%; deposits grew 1.9% to $3.29 billion. FHLB advances rose 39.3% to $110.9 million. Stockholders’ equity increased 3.8% to $500.0 million, or 12.5% of assets.
- Liquidity and capital: Cash and cash equivalents were 3.1% of assets; $544.0 million of available-for-sale securities were unpledged. Heritage Bank was categorized as well capitalized; its common equity Tier 1 ratio was 11.7%, Tier 1 leverage ratio 10.1% and total risk-based capital ratio 12.7%.
- Credit quality: Nonperforming assets were $11.8 million, or 0.29% of assets, versus $11.7 million, or 0.30%, at year-end. Nonperforming loans were 0.40% of loans; allowance coverage of nonperforming loans was 298.5%. Potential problem loans declined to $84.1 million from $87.8 million. The allowance for loan losses was $32.8 million, or 1.19% of gross loans.
Material changes versus comparable periods
- Q2 and first-half earnings growth reflected higher noninterest income and modestly higher net interest income, partly offset by higher operating expenses and funding costs.
- Loan-sale gains were a significant contributor: Q2 gain on sale of loans was $4.1 million, including a $3.0 million gain on sale of a previously classified purchased credit-impaired loan. First-half gains were $5.3 million, versus $2.0 million a year earlier.
- Loan growth was funded by both deposit growth and higher FHLB borrowing. Certificates of deposit rose to 11.9% of deposits from 11.1%; the increase included $47.1 million of brokered CDs.
- First-half net charge-offs were $330,000, compared with $3.6 million in the prior-year period. The allowance ratio rose slightly from 1.18% at year-end.
Outlook, commentary, risks and unusual items
- The filing provides no specific earnings or financial guidance. Management said purchased-loan accretion income is expected to continue declining as acquired loan balances run off; this income was $2.7 million for the first half versus $4.1 million in the prior-year period.
- On July 26, 2017, the company announced an all-stock agreement to acquire Puget Sound Bancorp for an indicated value of approximately $126.1 million at the then-current Heritage share price. Closing, expected in Q1 2018, is subject to regulatory and shareholder approvals and customary conditions; consideration value may fluctuate.
- A Washington State Department of Revenue audit has a preliminary finding of approximately $1.6 million, including interest, concerning B&O tax treatment of FDIC shared-loss payments. Management does not consider a material loss probable at this time, but says resolution could affect future results.
- Key disclosed risks include credit deterioration, interest-rate and funding-cost changes, economic and real-estate conditions, regulatory actions, acquisition integration, competition, operating costs, cybersecurity and third-party service disruptions. Management reported no material change in the risk factors from the 2016 Form 10-K and no material change in interest-rate risk exposure.
- Management stated that disclosure controls were effective as of June 30, 2017, with no material change in internal control over financial reporting during the quarter. The filing reports no material pending legal proceedings beyond ordinary routine litigation.
Important facts for investors to verify
- Whether earnings growth persists excluding the $3.0 million one-time purchased-loan sale gain, and how mortgage and other loan-sale gains develop.
- Whether loan growth can be funded without materially increasing deposit pricing, brokered CDs or FHLB advances, and how those funding costs affect net interest margin.
- Trends in potential problem loans, troubled debt restructurings, nonperforming assets, charge-offs and allowance adequacy as the portfolio expands.
- The final tax-audit outcome and any resulting expense, as well as regulatory and shareholder approvals, terms and integration risks for the Puget Sound Bancorp acquisition.
- The effect of adopting CECL, which the company anticipated for January 1, 2020; management had not yet determined the potential allowance increase or financial-statement impact.