Heritage Financial Corporation — 2016 Q3 Form 10-Q
Business context and period. Heritage is a Washington bank holding company operating Heritage Bank, with 63 branches across Washington and the greater Portland, Oregon area. Its business is primarily commercial lending and deposits, with additional mortgage, construction, and consumer lending. This unaudited report covers the quarter and nine months ended September 30, 2016; balance-sheet comparisons are with December 31, 2015.
Financial performance and position
| Metric | Q3 2016 / September 30, 2016 | Comparable period / prior date |
|---|---|---|
| Net income | $11.0 million; diluted EPS $0.37 | Q3 2015: $9.5 million; $0.32 |
| Nine-month net income | $29.0 million; diluted EPS $0.97 | Nine months 2015: $28.0 million; $0.93 |
| Net interest income | Q3: $33.6 million; nine months: $99.5 million | Q3 2015: $31.9 million; nine months 2015: $97.1 million |
| Net interest margin | Q3: 3.95%; nine months: 4.00% | Q3 2015: 4.00%; nine months 2015: 4.17% |
| Noninterest income | Q3: $9.9 million; nine months: $23.4 million | Q3 2015: $9.5 million; nine months 2015: $24.8 million |
| Noninterest expense | Q3: $26.8 million; nine months: $79.7 million | Q3 2015: $27.3 million; nine months 2015: $79.4 million |
| Efficiency ratio | Q3: 61.7%; nine months: 64.8% | Q3 2015: 65.9%; nine months 2015: 65.2% |
| Total assets | $3.85 billion | December 31, 2015: $3.65 billion |
| Net loans | $2.55 billion | December 31, 2015: $2.37 billion |
| Deposits | $3.24 billion | December 31, 2015: $3.11 billion |
| Cash and cash equivalents | $112.8 million | December 31, 2015: $126.6 million |
| Stockholders’ equity | $496.0 million; 12.9% of assets | December 31, 2015: $470.0 million |
- Profit and margins: Q3 net income rose 16.3% year over year, while nine-month net income increased 3.7%. Net interest income grew on higher average earning assets, but margin declined as asset yields softened; management cited lower loan rates and reduced accretion income from acquired loans. Management expected continued margin pressure from the low-rate environment and runoff of higher-yielding acquired loans.
- Revenue and expenses: Q3 noninterest income increased year over year, helped by a $2.1 million gain on sale of a previously classified purchased credit-impaired loan; the prior-year quarter included a $1.7 million gain from terminating FDIC shared-loss agreements. Nine-month noninterest income declined, in part because 2015 included the shared-loss termination gain and a $1.7 million Merchant Visa portfolio sale gain. Q3 expenses fell, while nine-month expenses were modestly higher, including increased compensation and occupancy costs.
- Cash flow: For the first nine months, operating cash flow was $40.3 million, investing cash flow was negative $192.4 million, and financing cash flow was positive $138.2 million. Cash and cash equivalents decreased $13.9 million to $112.8 million. Investing outflows chiefly reflected securities purchases and net loan originations; financing included deposit growth and net FHLB advances.
- Funding and liquidity: Deposits increased $134.1 million; non-maturity deposits represented 88.6% of deposits, up from 86.5% at year-end. The Bank had $17.7 million of FHLB advances outstanding and $22.4 million of repurchase agreements. It reported FHLB and Federal Reserve credit facilities of $664.5 million and $51.2 million, respectively, plus $90.0 million in correspondent-bank federal funds lines; no federal funds were outstanding. Available-for-sale securities totaled $819.2 million, of which $562.6 million were not pledged.
- Debt and capital: Junior subordinated debentures were $19.6 million, with a floating rate tied to three-month LIBOR; the reported rate was 2.41% at quarter-end. Heritage Bank was categorized as well capitalized. Its reported ratios were 11.7% common equity Tier 1, 10.2% Tier 1 leverage, 11.7% Tier 1 risk-based capital, and 12.7% total capital.
Material changes, risks and outlook
- Loans grew 7.4% from year-end, led by commercial real estate, commercial and industrial, construction, and consumer lending. Commercial business loans were 78.3% of gross loans.
- The allowance for loan losses was $30.2 million, or 1.17% of net loans, compared with $29.7 million, or 1.24%, at year-end. Nine-month net charge-offs increased to $3.3 million from $2.0 million a year earlier. Nonaccrual loans rose to $11.5 million from $9.7 million; nonperforming assets were 0.30% of assets. Potential problem loans decreased to $101.0 million from $110.4 million.
- Management considered the allowance appropriate but cautioned that economic deterioration, borrower or collateral developments, or regulatory review could require higher provisions. Other risks include interest-rate and margin changes, commercial real estate and construction credit exposure, competition, regulatory actions, cyber or third-party disruptions, and integration or acquisition risks.
- The Washington State Department of Revenue’s preliminary B&O tax audit findings for 2010–2014 were approximately $1.6 million including interest, largely relating to FDIC shared-loss payments. Management said a material loss was not probable at that time, but resolution could affect future results.
- On October 26, 2016, after quarter-end, the Board declared a regular $0.12-per-share dividend and a special $0.25-per-share dividend, payable November 22 to shareholders of record November 8. No specific earnings guidance was provided. The filing cautions that interim results are not necessarily indicative of full-year results.
- The Bank reported no material change in interest-rate risk exposure from the prior annual report. Disclosure controls were deemed effective, and the filing reported no material change in internal control over financial reporting. No material pending legal proceedings were reported apart from routine litigation.
Important facts for investors to verify
- Whether loan growth and deposit mix can be sustained without further net interest margin compression.
- Trends in commercial real estate and construction credit, nonaccrual loans, potential problem loans, charge-offs, and allowance coverage.
- The final outcome and any financial-statement impact of the Washington B&O tax audit.
- Liquidity and funding needs as lending expands, including use of FHLB advances and pledged securities.
- The effects of purchased-loan runoff, acquired-loan accretion, and the post-quarter special dividend on future earnings and capital.