Heritage Financial Corporation — Q2 2015 Form 10-Q
Business context and period. The unaudited filing covers the three and six months ended June 30, 2015. Heritage Financial is a Washington-based bank holding company operating Heritage Bank, focused principally on commercial lending and deposits in Washington and the greater Portland, Oregon area. Results include a full six months of Washington Banking Company operations in 2015 versus only two months in the comparable 2014 periods, so year-over-year comparisons are materially affected by the May 2014 merger.
Financial performance
| Metric | Q2 2015 | Q2 2014 | Six months 2015 | Six months 2014 |
|---|---|---|---|---|
| Net interest income | $32.5 million | $28.6 million | $65.1 million | $45.3 million |
| Noninterest income | $6.9 million | $4.8 million | $15.2 million | $7.1 million |
| Provision for loan losses | $1.2 million | $0.7 million | $2.4 million | $1.1 million |
| Noninterest expense | $26.1 million | $27.0 million | $52.1 million | $41.8 million |
| Net income | $8.7 million | $4.1 million | $18.5 million | $6.7 million |
| Diluted EPS | $0.29 | $0.16 | $0.61 | $0.32 |
| Net interest margin | 4.19% | 4.55% | 4.25% | 4.52% |
| Efficiency ratio | 66.3% | 80.9% | 64.8% | 79.7% |
Management attributed higher earnings primarily to the Washington Banking merger and increased loan-sale gains. Net interest income rose 13.5% in Q2 and 43.7% for the half, while margins contracted. Management said low interest rates and expected reductions in higher-yielding purchased loans could continue to pressure margins. The efficiency ratio improved, reflecting greater scale and the absence of substantial 2014 merger-related costs.
Q2 noninterest income included $1.3 million of loan-sale gains and $425,000 of securities-sale gains. First-half other income included a $1.7 million gain from the January sale of the merchant Visa portfolio; management expects lower Visa income following that sale. First-half noninterest expense rose 24.8%, including higher staffing and occupancy costs associated with the merger, partly offset by lower merger-related data-processing and professional-service expenses.
Financial position, liquidity and capital
- At June 30, 2015, total assets were $3.48 billion, up $22.6 million from year-end 2014. Net loans were $2.32 billion; noncovered loans grew 5.4% from year-end, with growth primarily in commercial real estate.
- Deposits were $2.95 billion, up $40.2 million. Non-maturity deposits represented 84.3% of deposits, compared with 81.9% at year-end; certificates of deposit declined to $461.2 million from $525.4 million.
- Cash and cash equivalents were $85.3 million, down $36.3 million over the half. Available-for-sale securities were $699.1 million, down $43.7 million. Management cited loan growth as a principal use of liquidity.
- Six-month operating cash flow was $18.4 million; investing cash outflow was $69.8 million and financing cash inflow was $15.1 million. Cash and cash equivalents decreased $36.3 million. Investing uses included $98.9 million of net loan originations and a $25.0 million bank-owned life insurance purchase.
- Repurchase-agreement borrowings were $20.6 million, down from $32.2 million at year-end; junior subordinated debentures were $19.3 million. The Bank reported no outstanding FHLB or Federal Reserve facility borrowings and no federal funds purchased; available facilities included $345.7 million from FHLB, $76.2 million from the Federal Reserve and $70.0 million of correspondent-bank lines.
- Stockholders’ equity was $459.1 million, or 13.2% of assets. The Bank was categorized as well capitalized; actual common-equity Tier 1, Tier 1 leverage, Tier 1 risk-based and total risk-based capital ratios were 12.8%, 10.4%, 12.8% and 13.9%, respectively.
Credit quality, changes and unusual items
- Nonperforming noncovered assets declined to $7.3 million (0.21% of noncovered assets) from $9.7 million (0.29%) at year-end. Nonaccrual noncovered loans were $7.0 million; nonaccrual covered loans were $3.5 million.
- Noncovered potential problem loans fell to $86.2 million from $117.3 million. The noncovered allowance was $22.8 million, equal to 1.02% of gross noncovered loans and 325.51% of nonperforming noncovered loans. The half-year provision increased from $349,000 to $2.5 million, which management attributed primarily to loan growth.
- On August 4, 2015, after quarter-end, the Bank and FDIC terminated shared-loss agreements covering the Cowlitz, City Bank and North County Bank acquisitions. The Bank paid $7.1 million; termination generated an approximately $1.7 million pretax gain and eliminated the $388,000 indemnification asset and $9.3 million clawback liability reported at June 30. The gain is a subsequent event, not Q2 income. Going forward, the Bank bears all covered-asset gains, losses, charge-offs and recoveries.
- The Company sold its entire private residential collateralized mortgage obligation portfolio in Q2 after downgrades, recording a $125,000 realized loss. It reported no securities other-than-temporarily impaired during the first half of 2015.
- The Board declared a $0.11-per-share dividend payable in August 2015. The company repurchased 441,966 shares under its eleventh repurchase plan during the first half for an average $16.64 per share.
Outlook, risks and contingencies
The filing provides no quantified earnings or growth guidance. Management expects continued net interest margin pressure. Key stated risks include credit deterioration and allowance adequacy, interest-rate and funding changes, real-estate values and economic conditions, regulatory capital requirements, and the ability to integrate acquisitions and control costs. The end of FDIC loss sharing shifts future covered-asset credit exposure entirely to the Bank. Management reported effective disclosure controls and no material change in internal control over financial reporting; it also reported no material pending litigation beyond routine business matters and no material changes to the 2014 Form 10-K risk factors.
Investor verification points
- Separate organic performance from the Washington Banking merger’s effect on year-over-year revenue, expenses and loan growth.
- Track net interest margin and loan yields against management’s warning of further margin pressure.
- Review commercial real estate concentrations, potential problem loans, charge-offs and allowance adequacy as the portfolio grows.
- Confirm the accounting and cash effects of the August FDIC termination, including the gain, liability release and future credit exposure.
- Assess recurring earnings excluding the merchant Visa portfolio sale gain and elevated loan- and securities-sale gains.
- Reconcile the filing’s branch-count disclosures: the business description states 67 offices, while MD&A reports 66 locations at June 30, 2015.