Heritage Financial Corporation — Q3 2017 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2017. Amounts are in U.S. dollars; financial figures below are generally rounded to millions. Heritage is a Washington-based bank holding company operating Heritage Bank, with 59 branches in Washington and the greater Portland, Oregon area, focused primarily on commercial lending and deposits.
Financial results and key metrics
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Net interest income | $35.0m | $33.6m | $102.3m | $99.5m |
| Provision for loan losses | $0.9m | $1.5m | $2.9m | $3.8m |
| Noninterest income | $8.4m | $9.9m | $26.4m | $23.4m |
| Noninterest expense | $28.0m | $26.8m | $83.0m | $79.7m |
| Net income | $10.6m | $11.0m | $31.8m | $29.0m |
| Diluted earnings per share | $0.35 | $0.37 | $1.06 | $0.97 |
| Net interest margin | 3.85% | 3.95% | 3.89% | 4.00% |
| Efficiency ratio | 64.4% | 61.7% | 64.5% | 64.8% |
At September 30, 2017, total assets were $4.05bn, up 4.4% from year-end 2016; net loans after allowance were $2.77bn, up 6.0%; deposits were $3.32bn, up 2.8%; and stockholders’ equity was $507.6m. Cash and cash equivalents were $111.3m. Funding included $117.4m of Federal Home Loan Bank advances, $28.7m of repurchase agreements, and $19.9m of junior subordinated debentures. The allowance for loan losses was $31.4m, or 1.12% of loans; nonperforming loans were 0.39% of net loans, with allowance coverage of 286.7%. Heritage Bank reported regulatory capital ratios of 11.6% common equity Tier 1, 10.0% Tier 1 leverage, 11.6% Tier 1 risk-based, and 12.5% total risk-based capital; the Bank was categorized as well capitalized.
For the first nine months, operating cash flow was $53.8m, investing cash flow was negative $169.9m, and financing cash flow was positive $123.6m, producing a $7.5m increase in cash and cash equivalents. Cash dividends paid were $11.4m.
Material changes versus comparable periods
- Q3 net income fell 3.8% year over year, despite 4.1% growth in net interest income, principally because noninterest income declined 14.9% and noninterest expense rose 4.2%. Lower loan-loss provision partly offset those pressures.
- Nine-month net income rose 9.5%, supported by 12.7% higher noninterest income and 2.9% higher net interest income, partly offset by 4.2% higher expenses.
- Net interest margin declined 10 basis points in Q3 and 11 basis points year to date. Management attributed pressure to rising funding costs and lower accretion income on acquired loans; it expects acquired-loan accretion to continue declining as those balances run off.
- Loan growth was funded mainly by deposits, supplemented by increased FHLB borrowing. Brokered certificates of deposit increased by $44.1m and contributed to the higher share of certificates in total deposits.
- Credit indicators were mixed: nonperforming assets declined to $11.5m from $11.7m at year-end and potential problem loans declined to $84.1m from $87.8m, while Q3 net charge-offs were $2.2m, including charge-offs on purchased credit-impaired loan pools.
Outlook, transactions, risks and unusual items
- Merger: Heritage agreed to acquire Puget Sound Bancorp in an all-stock transaction valued at approximately $126.1m using Heritage’s July 26 share price. Puget Sound shareholders are to receive 1.320 Heritage shares per share, subject to potential adjustment; they would own approximately 13.5% of the combined company. Closing was expected in Q1 2018, subject to regulatory, shareholder and other approvals. The filing gives no earnings guidance.
- Merger costs: Management cited legal costs related to the proposed transaction as a contributor to higher Q3 professional-services expense.
- Tax audit contingency: Washington’s Department of Revenue issued preliminary B&O tax findings of approximately $1.6m, including interest, concerning FDIC shared-loss payments for 2010–2014. Management did not consider a material loss probable but said the outcome could affect future results.
- Credit and market risks: The loan book is concentrated in commercial lending (78.6% of gross loans), including non-owner-occupied commercial real estate (33.3%). Management warns that economic or real-estate deterioration, borrower and collateral developments, or regulatory review could require higher provisions or allowance. Rising rates and funding costs may also affect margin and earnings.
- Accounting changes: Heritage anticipated adopting revenue-recognition guidance in January 2018 and the expected-credit-loss (CECL) standard in January 2020. Management had not determined the potential magnitude of any CECL allowance increase.
- Capital return: On October 25, 2017, the Board declared a regular dividend of $0.13 and a special dividend of $0.10 per share, payable November 22, 2017. These declarations followed the quarter-end.
- Management reported disclosure controls were effective and no material change in internal control over financial reporting during the quarter. The filing says there were no material changes to the risk factors in the 2016 Form 10-K.
Important facts for investors to verify
- Whether the Puget Sound transaction received required approvals, closed on schedule, and achieved expected integration benefits without materially higher costs or customer attrition.
- How deposit pricing, brokered funding and borrowing costs affect net interest margin as acquired-loan accretion declines.
- Whether commercial real-estate and other credit quality indicators, charge-offs and the allowance remain appropriate as loans grow.
- The resolution and ultimate financial impact, if any, of the Washington B&O tax audit.
- The expected CECL adoption impact on allowance levels, capital, implementation costs and reporting processes.
- Whether liquidity, regulatory capital and dividend capacity remain adequate as growth and merger-related needs evolve.