Heritage Financial Corporation — Q3 2015 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2015. Amounts are in U.S. dollars; financial statement amounts are generally in millions unless noted. Heritage is a Washington-based bank holding company operating Heritage Bank, with 67 branches in Washington and the greater Portland, Oregon area. Its core business is commercial lending and deposit services. The 2014 comparable periods include the Washington Banking merger only from May 1, 2014, making year-to-date comparisons affected by merger timing.
Financial performance and position
| Metric | Q3 2015 | Q3 2014 | Nine months 2015 | Nine months 2014 |
|---|---|---|---|---|
| Net income | $9.5 | $7.1 | $28.0 | $13.8 |
| Diluted EPS | $0.32 | $0.23 | $0.93 | $0.57 |
| Net interest income | $31.9 | $33.3 | $97.1 | $78.6 |
| Provision for loan losses | $0.9 | $0.6 | $3.2 | $1.7 |
| Noninterest income | $9.5 | $5.5 | $24.8 | $12.6 |
| Noninterest expense | $27.3 | $28.4 | $79.4 | $70.1 |
| Net interest margin | 4.00% | 4.32% | 4.17% | 4.43% |
| Efficiency ratio | 65.9% | 73.1% | 65.2% | 76.9% |
Q3 net income rose 34.3%, with management attributing the increase mainly to a $1.7 million pretax gain from terminating FDIC shared-loss agreements, higher loan-sale gains and lower other-real-estate-owned expense. Nine-month net income rose 103.5%, primarily reflecting the Washington Banking merger and increased loan-sale gains. The efficiency ratio improved, helped by higher noninterest income and, for the year-to-date period, merger-related scale; margin compression partly offset that improvement.
Balance sheet, liquidity and capital at September 30, 2015
- Total assets were $3.60 billion, up 4.0% from December 31, 2014. Net loans were $2.38 billion, up 6.8%; deposits were $3.05 billion, up 5.1%.
- Cash and cash equivalents were $142.5 million. Available-for-sale securities were $703.1 million, of which $480.5 million were not pledged, according to management. Non-maturity deposits were 85.7% of deposits, versus 81.9% at year-end 2014.
- Stockholders’ equity was $468.7 million, or 13.0% of assets. Heritage Bank reported 12.2% common equity Tier 1, 10.3% Tier 1 leverage and 13.2% total capital ratios, and was categorized as well capitalized.
- Liabilities included $3.05 billion of deposits, $22.8 million of repurchase agreements and $19.4 million of junior subordinated debentures. The debentures carry a variable rate based on three-month LIBOR plus 1.56%; the reported rate was 1.89% at quarter-end.
- The Bank reported no outstanding borrowings on its $501.3 million FHLB and $57.3 million Federal Reserve credit facilities, or on $90.0 million of correspondent-bank federal funds lines.
Cash flow for the nine months
Operating activities provided $33.2 million; investing activities used $134.3 million; and financing activities provided $122.0 million. Cash and cash equivalents increased $20.8 million to $142.5 million. Investing outflows included $156.1 million of net loan originations, $158.0 million of securities purchases and $25.0 million to purchase bank-owned life insurance; deposit growth provided $147.9 million in financing cash flow.
Material changes and asset quality
- Quarterly net interest income declined 4.1% year over year despite higher average loans. Loan yield fell to 5.08% from 5.76%, and net interest margin fell 32 basis points. Management cited lower contractual loan rates and lower purchased-loan accretion. It expects continued downward pressure on margin from the low-rate environment and projected reductions in higher-yielding purchased loans.
- Year-to-date net interest income increased 23.4%, principally due to the merger and loan growth, while margin declined 26 basis points. The comparison is not like-for-like: 2015 includes nine months of legacy Washington Banking operations, compared with five months in 2014.
- Nonperforming assets fell to $12.0 million, or 0.33% of assets, from $14.9 million, or 0.43%, at year-end 2014. Nonaccrual loans were $9.9 million; potential problem loans declined to $113.3 million from $162.9 million. Performing troubled debt restructurings increased to $32.5 million from $29.1 million.
- The allowance for loan losses was $29.0 million, or 1.21% of net loans, versus $27.7 million, or 1.23%, at year-end. Management considered it adequate, but disclosed that deterioration or regulatory review could require additional provision.
Unusual items, outlook and risks
- On August 4, 2015, the Bank paid the FDIC $7.1 million to terminate shared-loss agreements covering prior acquisitions. Termination eliminated the $0.4 million indemnification asset and $9.3 million clawback liability at the termination date and produced a $1.7 million pretax gain. The Bank now bears future covered-asset gains, losses, charge-offs and recoveries without FDIC sharing.
- The Company sold its merchant Visa portfolio in January 2015, recording a $1.7 million gain; management expects lower merchant Visa income as a result. It also purchased $25.0 million in bank-owned life insurance during Q2 2015.
- Q3 data-processing expense included a $429,000 contract cancellation fee. Nine-month expenses also reflect continuing costs associated with the Washington Banking merger, while 2014 included merger-related professional and system-conversion costs.
- On October 21, 2015, the Board declared a regular $0.11-per-share dividend and a special $0.10-per-share dividend, payable November 18, 2015. These were declared after quarter-end.
- Key disclosed risks include interest-rate and net-interest-margin sensitivity; credit deterioration, especially in commercial real estate, construction and business lending; potential inadequacy of loan-loss allowances; economic and real-estate-market weakness; regulatory capital or examination actions; acquisition integration; expense control; and cybersecurity or third-party service disruptions. Management reported no material change in market-risk exposure, no material change in risk factors from the 2014 Form 10-K, and effective disclosure controls as of quarter-end. No material pending legal proceedings were reported.
Important facts for investors to verify
- Whether core earnings growth persists after excluding the FDIC termination gain, Visa portfolio sale gain, loan-sale gains and other recoveries.
- Whether margin compression continues as purchased-loan accretion declines and interest rates or deposit costs change.
- Trends in commercial loan quality, potential problem loans, troubled restructurings, charge-offs and the adequacy of the $29.0 million allowance.
- The financial effect of ending FDIC loss-sharing, including future credit costs now borne entirely by the Bank.
- Deposit growth and mix, available unpledged liquidity, capital levels and the capacity to sustain dividends and repurchases under evolving capital requirements.
- Merger-related cost savings and integration progress, while recognizing that the year-to-date 2015 and 2014 results have different periods of legacy Washington Banking operations.