Heritage Financial Corporation — Q1 2014 Form 10-Q
Reporting period: Three months ended March 31, 2014; comparative income and cash-flow figures are for Q1 2013. Balance-sheet comparisons are against December 31, 2013. Amounts below are in millions unless otherwise noted.
Business context
Heritage is a Washington bank holding company operating Heritage Bank, serving small businesses and other customers across Washington and the greater Portland, Oregon area. The company reported 36 branches. Its strategy emphasizes commercial lending, market-area expansion and asset quality. The quarter’s results include continuing costs from acquisitions and integration initiatives.
Financial performance and condition
| Metric | Q1 2014 / March 31, 2014 | Comparable period / prior year-end |
|---|---|---|
| Net interest income | $16.7 | $16.6 in Q1 2013 |
| Net interest margin | 4.48% | 5.20% in Q1 2013 |
| Provision for loan losses | $0.46 | $0.86 in Q1 2013 |
| Noninterest income | $2.31 | $2.25 in Q1 2013 |
| Noninterest expense | $14.78 | $13.72 in Q1 2013 |
| Net income / diluted EPS | $2.54 / $0.16 | $2.89 / $0.19 in Q1 2013 |
| Efficiency ratio | 77.6% | 72.9% in Q1 2013 |
| Total assets | $1,662.5 | $1,659.0 at December 31, 2013 |
| Total loans, net of allowance | $1,207.7 | $1,203.1 at December 31, 2013 |
| Deposits | $1,404.2 | $1,399.2 at December 31, 2013 |
| Stockholders’ equity | $216.4 | $215.8 at December 31, 2013 |
Cash and cash equivalents were $154.4, or 9.32% of assets. Quarterly cash flows were $5.5 provided by operations, $15.5 provided by investing and $3.0 provided by financing; cash increased $24.0. The company had $28.8 of repurchase-agreement funding outstanding. The Bank reported no borrowings on its $327.6 FHLB and $54.5 Federal Reserve credit facilities, and no federal funds purchased. Management described capital as strong: the Bank’s leverage, Tier 1 risk-based and total risk-based capital ratios were 11.2%, 14.9% and 16.2%, respectively, and it was categorized as well capitalized.
Changes and asset quality
- Net income declined $0.34, or 11.9%, year over year. Higher operating costs more than offset lower loan-loss provisions and modestly higher net interest income.
- Net interest margin fell 72 basis points. Management attributed the decline to lower contractual loan yields and lower accretion income on acquired loans; it expects further margin pressure as rates remain low and higher-yielding purchased loans pay down.
- Noninterest expense rose 7.7%, reflecting acquisition and merger activity, Valley-related costs, occupancy expenses and system/branch initiatives. Identified initiative costs were $0.79 in Q1 2014, including $0.43 related to Valley and $0.33 for the proposed Washington Banking merger.
- Nonperforming originated loans increased to $10.6 from $6.9 at year-end; the ratio to originated loans rose to 0.89% from 0.53%. Management cited a downgraded $4.2 borrower relationship. Potential problem originated loans increased to $41.7 from $34.5.
- The originated-loan allowance was $17.5, or 1.76% of originated loans; coverage of nonperforming originated loans was 199.15%. Q1 originated-loan net recoveries were $0.18, compared with net charge-offs of $1.71 in Q1 2013.
Outlook, transactions and risks
Management expects net interest margin to continue declining in future periods. It said expenses may remain elevated while growth strategies are implemented, but expects expenses to become more consistent with revenue over time. The filing provides no specific earnings or revenue guidance.
The proposed Washington Banking Company merger had received regulatory approvals but remained subject to customary closing conditions. It was expected to close May 1, 2014. Under the agreement, Washington Banking shareholders would receive 0.89 Heritage shares and $2.75 cash per share; the filing estimated aggregate consideration of approximately $296.7 and ownership of about 46% for Washington Banking shareholders after closing. On April 4, 2014, the parties entered an agreement in principle to settle a shareholder lawsuit; court approval and a definitive settlement remained outstanding. The proposed settlement would not change merger consideration.
Principal risks include credit deterioration, commercial real-estate and construction exposure, interest-rate and margin sensitivity, acquisition integration and execution, regulatory capital and liquidity requirements, and legal and technology risks. Management cautioned that regulators may require additional loan-loss reserves. It reported no material change in previously disclosed risk factors, no material change in interest-rate risk exposure, and effective disclosure controls.
Investor verification points
- Track whether margin compression and acquired-loan runoff develop as management expected, and assess effects on earnings.
- Review the $4.2 borrower relationship, rising nonperforming and potential problem loans, and adequacy of loan-loss allowances.
- Verify completion and integration of the Washington Banking merger, realized cost savings, and resulting capital and shareholder dilution.
- Monitor the shareholder-litigation settlement process and any related costs or conditions.
- Assess the sustainability of dividends against earnings, capital requirements and the Bank’s ability to upstream dividends.