Heritage Financial Corporation — Q3 2011 Form 10-Q
Business context and period. Unaudited consolidated results for the three and nine months ended September 30, 2011. Heritage is a Washington-based bank holding company focused on commercial and other lending and deposits in Washington and the greater Portland, Oregon area. The filing reflects the Cowlitz and Pierce bank acquisitions completed in 2010.
Key financial results
| Metric | Q3 2011 | Q3 2010 | Nine months 2011 | Nine months 2010 |
|---|---|---|---|---|
| Net interest income | $17.3 million | $12.7 million | $51.1 million | $34.1 million |
| Net income | $1.8 million | $2.0 million | $4.3 million | $3.6 million |
| Net income per diluted share | $0.12 | $0.15 | $0.28 | $0.23 |
| Provision for loan losses, originated and purchased | $3.2 million | $2.2 million | $11.1 million | $9.1 million |
| Non-interest income | $0.9 million | $2.9 million | $5.2 million | $7.1 million |
| Non-interest expense | $12.4 million | $10.3 million | $39.2 million | $26.7 million |
| Net interest margin | 5.47% | 4.42% | 5.49% | 4.53% |
| Efficiency ratio | 68.3% | 66.2% | 69.8% | 64.9% |
Amounts are rounded. For the nine-month period, operating cash flow was $16.3 million, investing cash flow was negative $31.6 million, and financing cash flow was negative $1.7 million. Cash and cash equivalents declined $17.0 million to $152.0 million.
At September 30, 2011, total assets were $1.369 billion; net loans were $984.3 million; deposits were $1.137 billion; repurchase-agreement funding was $18.8 million; total liabilities were $1.163 billion; and shareholders’ equity was $206.1 million. The company reported no outstanding borrowings other than repurchase agreements. Cash and cash equivalents were 11.1% of assets. Banks had uncommitted credit facilities of $183.3 million with the FHLB and $73.0 million with the Federal Reserve, plus $22.8 million in federal-funds lines.
Consolidated regulatory capital ratios were 14.1% Tier 1 leverage, 20.4% Tier 1 risk-based, and 21.7% total risk-based. Both subsidiary banks were classified as well capitalized. The company reported capital equal to 15.1% of total assets.
Changes and drivers versus comparable periods
- Q3 net income declined year over year despite higher net interest income: the $4.6 million increase in net interest income was outweighed by higher provisions and expenses and lower non-interest income. Nine-month net income increased, principally as net interest income rose $16.9 million.
- Higher loan balances and yields, including discount accretion on acquired Cowlitz and Pierce loan portfolios, lifted net interest income and margin. Acquired-loan discount accretion added about 91 basis points to Q3 loan yield in 2011, versus 12 basis points in Q3 2010.
- Funding costs fell: average interest-bearing deposit rates and total interest-bearing liability rates were lower than in 2010. Deposits were broadly stable versus year-end 2010, but non-maturity deposits increased $55.4 million while certificates of deposit declined $54.3 million.
- Non-interest expense rose substantially, primarily due to the acquisitions, including staffing and occupancy costs. Management said expenses were expected to become more aligned with revenue as growth strategies produce longer-term results; no numerical earnings guidance was provided.
- Non-interest income was reduced by a $1.7 million Q3 and $2.6 million nine-month negative change in the FDIC indemnification asset. Prior-year comparisons also included a $438,000 acquisition gain.
- Gross originated loans increased to $804.5 million from $743.3 million at year-end 2010, while purchased covered and non-covered loan balances declined. Total net loans increased modestly to $984.3 million from $979.7 million.
Credit quality, outlook, risks and unusual items
- Originated nonperforming assets were $27.8 million, or 2.20% of originated assets, down from $29.5 million, or 2.38%, at year-end 2010. Originated nonaccrual loans were $25.8 million. Potential problem originated loans declined to $39.0 million from $56.1 million.
- Originated-loan allowance was $22.4 million, equal to 2.79% of originated loans and 94.7% of originated nonperforming loans. Purchased-loan allowances were $3.7 million on covered loans and $2.4 million on non-covered loans. Management considered the allowance appropriate but warned that deterioration or regulatory review could require additional reserves.
- Originated troubled debt restructurings increased to $20.0 million, including $7.2 million accruing and $12.7 million nonaccruing. Adoption of updated TDR guidance led to reassessment; the filing identifies $8.8 million of TDRs from that reassessment for the three and nine months ended September 30.
- Credit risks include commercial real estate and construction lending, borrower cash flows, local economic and property-market conditions, and performance of acquired loans. For covered acquired loans, additional loss provisions may be offset by FDIC indemnification, subject to the loss-share arrangements. The indemnification asset fell to $12.1 million from $16.1 million at year-end.
- The company recorded $73,000 of net investment-security impairment expense for the first nine months. It judged other reported unrealized security losses to be temporary. A stock-price decline triggered an interim goodwill impairment test; no goodwill charge was required.
- On August 17, 2011, the company repurchased its remaining U.S. Treasury warrant for $450,000, completing repayment of its TARP obligations after redeeming preferred shares in December 2010. It repurchased 69,300 common shares during Q3 at an average $11.40 under a plan authorizing repurchases of up to approximately 782,000 shares.
- The board declared a $0.05-per-share dividend payable in November 2011. Payment depends on earnings, capital and regulatory constraints. Management reported no material change in interest-rate risk exposure; the company does not maintain a trading account or use hedging activities.
- Management cited economic, interest-rate, credit, real-estate, regulatory, valuation, technology, litigation and acquisition-integration risks. It reported disclosure controls effective and no material change in internal control over financial reporting. Pending legal proceedings were not expected to have a material aggregate effect.
Important facts for investors to verify
- How much of reported net interest margin and earnings depends on acquired-loan discount accretion, and how sustainable that contribution is.
- Trends in criticized, nonaccrual and restructured loans, especially construction and commercial credits, and adequacy of originated and purchased-loan allowances.
- Future changes in the FDIC indemnification asset, loss-share recoveries and covered-loan performance.
- Whether acquisition-related expense growth moderates and efficiency improves as management expects, without quantified guidance.
- Liquidity, deposit mix and availability of the stated uncommitted facilities; capital ratios and dividend capacity remain subject to regulatory requirements.