Heritage Financial Corporation — 2016 Form 10-K Summary
Business context and reporting period. This annual report covers the fiscal year ended December 31, 2016; quarterly data are also provided for Q4 2016. Heritage is a Washington bank holding company operating Heritage Bank, with 63 branches in Washington and Oregon. Its community-banking business centers on small-business lending and deposits, particularly commercial lending. No acquisitions or mergers were completed in 2016.
Financial performance and position
| Metric | 2016 | Comparison |
|---|---|---|
| Net interest income | $132.5 million | Up 2.2% from 2015 |
| Net income | $38.9 million; diluted EPS $1.30 | Up 3.8%; $37.5 million and $1.25 per share in 2015 |
| Net interest margin | 3.96% | Down 15 basis points from 4.11% |
| Efficiency ratio | 64.9% | Improved from 65.6% |
| Operating cash flow | $54.0 million | Compared with $51.4 million in 2015 |
| Cash and cash equivalents | $103.7 million | Down from $126.6 million at year-end 2015 |
| Total assets | $3.88 billion | Up 6.3% year over year |
| Net loans / deposits | $2.61 billion / $3.23 billion | Loans up 10.0%; deposits up 3.9% |
| Stockholders’ equity | $481.8 million | Up 2.5%; equity/assets ratio was 12.4% |
Interest income increased 2.0% to $138.5 million; interest expense declined 1.9% to $6.0 million. The $4.9 million loan-loss provision was up from $4.4 million. Net charge-offs rose to $3.6 million from $2.4 million. Noninterest income declined 2.0% to $31.6 million, while noninterest expense was nearly flat at $106.5 million. The effective tax rate was 26.2%, versus 26.9%.
Q4 2016. Net income was $9.9 million, or $0.33 per diluted share, compared with $9.5 million, or $0.32 per share, in Q4 2015. Quarterly net interest income was $33.1 million and provision for loan losses was $1.2 million.
Cash flow and funding. Investing activities used $252.9 million, primarily reflecting net loan growth and securities purchases; financing activities provided $176.1 million. Cash and cash equivalents decreased by $22.9 million over the year. Year-end borrowings included $79.6 million of FHLB advances, $22.1 million of repurchase agreements, and $19.7 million of junior subordinated debentures. The Bank had a $549.0 million FHLB facility, of which $79.6 million was drawn, plus a $45.9 million Federal Reserve facility with no advances outstanding and $90.0 million in federal-funds lines.
Asset quality and capital. Nonperforming loans were $10.9 million, or 0.41% of net loans, compared with $9.7 million, or 0.40%, a year earlier. The allowance was $31.1 million, equal to 1.18% of loans and 284.93% of nonperforming loans. Commercial business loans were 78.7% of gross loans; non-owner-occupied commercial real estate represented 33.4%. The Bank was well capitalized: CET1 ratio 11.7%, Tier 1 risk-based ratio 11.7%, total risk-based ratio 12.7%, and leverage ratio 10.0%.
Material changes versus prior periods
- Loan growth, led by non-owner-occupied commercial real estate, drove asset expansion; commercial-property construction and land-development loans rose 96.6% to $108.8 million.
- Margin pressure continued: net interest margin fell to 3.96%, reflecting lower loan yields and reduced accretion from acquired loans. Purchased-loan accretion income declined to $7.2 million from $10.3 million.
- Deposit mix improved: non-maturity deposits rose to 88.9% of deposits from 86.5%; certificates of deposit fell to 11.1% from 13.5%.
- Nonperforming loans increased modestly, but potential problem loans declined to $87.8 million from $110.4 million. Net charge-offs increased, particularly in commercial business loans.
- 2016 noninterest income lacked two 2015 items: the $1.7 million gain on termination of FDIC shared-loss agreements and the $2.2 million gain on sale of the Merchant Visa portfolio. Higher loan-sale gains and interest-rate-swap fees partly offset their absence.
- Cash dividends declared were $0.72 per share, including a $0.25 special dividend; the company repurchased 138,000 shares under its repurchase plan.
Outlook, commentary, risks and unusual items
- Management’s strategy emphasizes measured Pacific Northwest expansion, deposit growth, commercial relationships, asset quality, and potential acquisitions or new branches. The filing provides no formal earnings or growth guidance.
- Management noted the Federal Reserve’s December 2016 rate increase and anticipated further increases in 2017, subject to economic conditions. Interest-rate simulations estimated that a 100-basis-point increase would reduce net interest income by $0.9 million in year one and $5.2 million in year two; a 200-basis-point increase was estimated to increase it by $2.0 million and $10.3 million, respectively. Results depend on uncertain assumptions.
- Credit risks include the concentration in commercial and real estate lending, borrower cash-flow and collateral uncertainty, construction-loan exposure, and the possibility that loan-loss reserves may prove inadequate. The company also flagged regional economic, interest-rate, liquidity, regulatory, cyber-security, competition, acquisition-integration, and goodwill-impairment risks.
- A Washington State Department of Revenue audit raised preliminary business-and-occupation tax findings of approximately $1.6 million, including interest, relating to 2010–2014. Management did not consider a material loss probable but said the ultimate liability remained uncertain and could affect future results.
- Four branches were scheduled for consolidation into existing branches in April 2017. The filing also describes $626.0 million of off-balance-sheet commitments to extend credit and letters of credit.
- CECL was expected to be adopted January 1, 2020; management was still assessing its potential effect and noted it could increase the allowance for credit losses. The auditor issued unqualified opinions on the financial statements and internal control over financial reporting; management reported effective disclosure controls and internal control.
Most important facts for investors to verify
- Whether loan growth and deposit growth can continue without further deterioration in margins or funding costs.
- Trends in commercial real estate concentrations, nonperforming and potential problem loans, charge-offs, and reserve adequacy.
- The ultimate resolution and financial impact, if any, of the approximately $1.6 million state tax audit finding.
- Actual sensitivity to interest-rate changes and the assumptions behind management’s materially different 100- and 200-basis-point scenarios.
- The impact of branch consolidations, CECL implementation, and any future acquisitions on expenses, capital, and earnings.