Heritage Financial Corporation — Q1 2017 Form 10-Q
Business context and reporting period
Heritage Financial is a Washington-based bank holding company operating Heritage Bank, with 59 branches in Washington and the greater Portland, Oregon area. Its business is primarily commercial lending and deposit-taking, alongside construction, consumer and residential mortgage lending. This unaudited filing covers the three months ended March 31, 2017; income and cash flow comparisons are to Q1 2016, and balance-sheet comparisons are to December 31, 2016. Amounts below are U.S. dollars.
Financial performance and condition
- Earnings: Net income was $9.316 million, up 2.5% from $9.091 million. Diluted EPS was $0.31 versus $0.30. The declared dividend was $0.12 per share versus $0.11.
- Revenue and margins: Net interest income rose 1.2% to $33.146 million; total noninterest income increased 5.1% to $7.349 million. Net interest margin declined to 3.89% from 4.04%, and net interest spread fell to 3.81% from 3.97%. The efficiency ratio increased to 67.2% from 66.3%.
- Expenses and taxes: Noninterest expense increased 3.2% to $27.223 million, with compensation and benefits up $903,000. Provision for loan losses declined to $867,000 from $1.139 million. Income tax expense was $3.089 million; the effective tax rate was 24.9%, including a $138,000 excess tax benefit from adoption of stock-compensation accounting guidance.
- Assets and lending: Total assets were $3.886 billion, up 0.2% since year-end. Gross loans were $2.661 billion, up 0.9%; real estate construction and development loans rose $18.7 million, while non-owner-occupied commercial real estate loans fell $6.7 million. Commercial business loans represented 78.1% of gross loans.
- Credit quality: The allowance for loan losses was $31.594 million, or 1.19% of loans, compared with $31.083 million, or 1.18%, at year-end. Nonperforming assets were $11.663 million, or 0.30% of assets, unchanged from year-end; nonaccrual loans were $10.877 million. Potential problem loans decreased to $82.8 million from $87.8 million. Net charge-offs were $356,000, versus $1.218 million in Q1 2016.
- Deposits, debt and liquidity: Deposits increased 0.4% to $3.243 billion; non-maturity deposits were 89.4% of the total. FHLB advances declined to $66.750 million from $79.600 million. Junior subordinated debentures were $19.790 million and repurchase-agreement obligations were $21.440 million. Cash and cash equivalents totaled $104.372 million. Available-for-sale securities were $783.021 million, of which $241.963 million fair value was pledged. The Bank had $623.9 million of FHLB credit capacity and $41.1 million of Federal Reserve credit capacity; neither facility’s full capacity should be treated as cash on hand.
- Cash flow: Operating activities provided $21.469 million; investing activities used $17.229 million; financing activities used $3.613 million. Cash and cash equivalents increased $627,000 to $104.372 million.
- Capital: Stockholders’ equity was $489.196 million, or 12.6% of assets. Heritage Bank was categorized as well capitalized; its reported common equity Tier 1 ratio was 11.8%, Tier 1 leverage ratio 10.0%, and total capital ratio 12.8%.
Material changes versus comparable periods
- Net income increased modestly, supported by higher net interest income and noninterest income, partly offset by greater noninterest expense and a lower net interest margin.
- Average interest-earning assets increased 5.8%, while their average yield declined to 4.09% from 4.22%. Average loan balances rose 10.0%, but loan yield fell to 4.70% from 5.07%; incremental purchased-loan accretion also declined to $1.170 million from $1.779 million.
- Noninterest income benefited from higher service charges and loan-sale gains. There was no investment-security sale gain in Q1 2017, compared with $560,000 in Q1 2016.
- Q1 2017 noninterest expense was $27.223 million versus $26.369 million in Q1 2016. Management discussion also states that expense increased $854,000; this is consistent with the statements, despite a sentence in the discussion that incorrectly describes the change as a decrease.
- Comprehensive income was $10.789 million versus $14.802 million, reflecting lower other comprehensive income from securities valuation changes.
Outlook, commentary, risks and unusual items
- The filing provides no specific earnings, revenue or margin guidance. Management says quarterly results are not necessarily indicative of full-year results and identifies net interest income, asset quality, interest rates and loan/deposit mix as important performance drivers.
- Management attributed margin pressure principally to lower asset yields and reduced purchased-loan accretion. It considered the loan-loss allowance appropriate based on its methodology and current portfolio assessment, while cautioning that economic deterioration or regulatory review could require higher provisions.
- Key stated risks include borrower and real-estate credit deterioration; changes in interest rates, funding costs and net interest margin; competition and economic conditions; regulatory actions; execution and integration of acquisitions; operating-cost control; litigation; and cybersecurity or third-party service disruptions. Management reported no material change in interest-rate risk exposure since the 2016 Form 10-K.
- A Washington State Department of Revenue audit of Whidbey Island Bank’s 2010–2014 business-and-occupation tax returns has preliminary findings of approximately $1.6 million, including interest, largely concerning FDIC shared-loss payments. Management said a material loss was not considered probable at the time, but the outcome remained uncertain and future estimates or payments could affect results.
- Management planned branch consolidations and transferred $2.687 million of premises and equipment to assets held for sale. The filing reports no material pending legal proceedings beyond routine litigation and no material changes to previously disclosed risk factors.
- The company adopted ASU 2016-09 in Q1 2017; the reported excess tax benefit was $138,000. It expects to adopt revenue-recognition guidance in 2018 and the credit-loss standard (CECL) in 2020; the CECL impact was still under evaluation and could increase the allowance.
- After quarter-end, the board declared a regular $0.13-per-share dividend, payable May 24, 2017. The Bank’s ability to pay dividends to the holding company is subject to regulatory limits.
Important facts for investors to verify
- Whether the 3.89% net interest margin and lower loan yields stabilize, and how much future earnings depend on purchased-loan accretion.
- Credit trends in commercial real estate and construction lending, the $82.8 million potential-problem-loan balance, and the adequacy of the $31.6 million allowance.
- The outcome and potential financial impact of the state B&O tax audit, including any change in management’s loss assessment.
- Deposit growth, deposit pricing, and use of FHLB advances and other wholesale funding as loan growth continues.
- Whether planned branch consolidations, expense growth and the rising efficiency ratio affect operating performance.
- Capital and dividend capacity, including regulatory restrictions on Bank-to-parent dividends and the future CECL implementation impact.