Heritage Financial Corporation — Q2 2019 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2019. Unaudited consolidated results. Heritage is a Washington-based bank holding company operating Heritage Bank, with 62 branches in Washington and the greater Portland, Oregon area. The 2018 Puget Sound and Premier mergers affect year-over-year comparisons; Premier closed July 2, 2018.
Financial results and position
| Metric | Q2 2019 | Q2 2018 | Six months 2019 | Six months 2018 |
|---|---|---|---|---|
| Net interest income | $50.5 million | $43.7 million | $100.3 million | $84.6 million |
| Net income | $16.0 million | $11.9 million | $32.5 million | $20.9 million |
| Diluted earnings per share | $0.43 | $0.35 | $0.88 | $0.62 |
| Net interest margin | 4.33% | 4.22% | 4.34% | 4.17% |
| Provision for loan losses | $1.4 million | $1.8 million | $2.3 million | $2.9 million |
| Noninterest income | $7.6 million | $7.6 million | $15.0 million | $15.1 million |
| Noninterest expense | $37.5 million | $35.7 million | $74.1 million | $72.5 million |
For Q2, net income rose 34.8%; for the first half, it rose 55.3%. Management attributed the growth primarily to higher net interest income, reflecting larger loan balances, higher loan yields and merger-related scale, partly offset by higher deposit costs. Net interest margin improved 11 basis points for Q2 and 17 basis points for the first half. The efficiency ratio improved to 64.62% for Q2 from 69.58%, and to 64.23% for the first half from 72.67%.
- Balance sheet at June 30: Total assets $5.38 billion; net loans $3.68 billion; available-for-sale securities $960.7 million; stockholders’ equity $796.6 million. Assets increased 1.1% from year-end 2018.
- Funding and debt: Deposits were $4.35 billion, down $84.7 million (1.9%) from December 31. Short-term FHLB advances were $90.7 million, versus none at year-end; repurchase agreements were $23.1 million, down from $31.5 million. Junior subordinated debentures were $20.4 million.
- Liquidity and cash flow: Cash and equivalents were $139.3 million, down $22.6 million in the first half. Operating cash flow was $37.1 million; investing cash flow was negative $42.4 million; financing cash flow was negative $17.3 million. The bank reported $827.7 million of available FHLB borrowing capacity and $43.6 million of Federal Reserve borrowing capacity. Unpledged available-for-sale securities were $710.7 million.
- Capital: Equity-to-assets ratio was 14.8%. The Bank’s actual ratios included 11.9% common equity Tier 1, 10.5% Tier 1 leverage and 12.7% total capital to risk-weighted assets; management said the Company and Bank met applicable capital requirements and the Bank remained well capitalized.
Changes, credit quality and notable items
- Net loans increased $62.8 million, or 1.7%, from year-end; construction and land development loans grew $39.2 million. Deposits fell as non-maturity balances declined $121.6 million, partly offset by $36.9 million growth in certificates of deposit.
- Credit indicators weakened from year-end: nonaccrual loans rose to $19.3 million from $13.7 million; nonperforming assets rose to $20.5 million from $15.7 million; potential problem loans increased to $114.1 million from $101.3 million. Allowance for loan losses was $36.4 million, 0.98% of net loans, versus 0.96% at year-end.
- Management cited five commercial relationships totaling $8.7 million moving to nonaccrual, including two agricultural relationships totaling $3.9 million. Eight commercial relationships totaling $30.3 million experienced cash-flow deterioration and were downgraded. Management considered the allowance appropriate but warned that economic deterioration or regulatory review could require additional provisions.
- Mortgage loan-sale gains declined, partly due to lower mortgage originations; the company said it retained some SBA loans rather than selling them. Lower acquisition-related costs and the absence of a prior-year $1.7 million contract buyout helped offset expense growth.
- Adoption of the lease accounting standard on January 1, 2019 recognized operating lease right-of-use assets of $27.3 million and liabilities of $28.6 million at June 30, and reduced opening retained earnings by $399,000, net of tax.
- The company anticipated adopting CECL on January 1, 2020. It was still assessing the impact and said the new standard may increase the allowance; the magnitude was not yet determined.
Outlook, risks and contingencies
The filing provides no specific earnings or financial guidance. Management said results are affected by interest rates, funding costs, loan and deposit growth, asset quality, and local and national economic conditions. Key disclosed risks include deterioration in commercial real estate or other markets, increased delinquencies and credit losses, deposit competition and rising funding costs, interest-rate and yield-curve changes, merger integration and retention, regulatory actions, and technology or third-party service disruptions. The company reported no material change in market-risk exposure from its 2018 Form 10-K, no material change in risk factors, and no material pending legal proceedings beyond routine banking litigation. Disclosure controls were assessed as effective; no material change in internal control over financial reporting was reported.
After quarter-end, the Board declared a regular dividend of $0.19 per share on July 24, 2019, payable August 22 to holders of record August 8.
Important facts for investors to verify
- Whether the increase in nonaccrual and potential problem loans continues, particularly in commercial and agricultural relationships, and whether the allowance remains adequate.
- How deposit outflows, certificate growth and FHLB borrowing affect funding costs and net interest margin.
- How much earnings growth reflects sustainable core operations versus merger scale and purchase-accounting accretion; purchased-loan accretion was $1.4 million in Q2 and $2.8 million in the first half.
- The eventual CECL adoption impact, which management had not yet quantified.
- Whether loan growth, capital ratios and liquidity remain consistent with management’s stated assessment and dividend capacity.