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HFWA > SEC Filings for HFWA > Form 10-Q on 30-Apr-2013All Recent SEC Filings

Show all filings for HERITAGE FINANCIAL CORP /WA/ | Request a Trial to NEW EDGAR Online Pro

Form 10-Q for HERITAGE FINANCIAL CORP /WA/


30-Apr-2013

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion is intended to assist in understanding the financial condition and results of the Company as of and for the three months ended March 31, 2013. The information contained in this section should be read with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes, and the December 31, 2012 audited Consolidated Financial Statements and the accompanying Notes included in our Annual Report on Form 10-K for the year ended December 31, 2012.

Overview

Heritage Financial Corporation is a bank holding company, which primarily engages in the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank (collectively, the "Banks"). We provide financial services to our local communities with an ongoing strategic focus in expanding our commercial lending relationships, market area and a continual focus on asset quality. At March 31, 2013, we had total assets of $1.45 billion and total stockholders' equity of $200.5 million. The Company's business activities generally are limited to passive investment activities and oversight of its investment in the Banks. Accordingly, the information set forth in this report relates primarily to the Banks' operations.

Our business consists primarily of lending and deposit relationships with small businesses and their owners in our market areas and attracting deposits from the general public. We also make real estate construction and land development loans and consumer loans and originate for sale or investment purposes first mortgage loans on residential properties located in western and central Washington State and the greater Portland, Oregon area.

Our core profitability depends primarily on our net interest income after provision for loan losses. Net interest income is the difference between interest income, which is the income that we earn on interest-earning assets, comprised primarily of loans and investments, and interest expense, the amount we pay on our interest-bearing liabilities, which are primarily deposits. The results of our operations may also be affected by local and general economic conditions. Changes in levels of interest rates affect our net interest income. Management strives to match the repricing characteristics of the interest earning assets and interest bearing liabilities to protect net interest income from changes in market interest rates and changes in the shape of the yield curve.

The provision for loan losses is dependent on changes in the loan portfolio and management's assessment of the collectability of the loan portfolio as well as prevailing economic and market conditions. The allowance for loan losses reflects the amount that the Company believes is appropriate to cover known and inherent credit losses in its loan portfolio. Additionally, net income is affected by noninterest income and noninterest expenses. For the three months ended March 31, 2013, noninterest income consisted of a bargain purchase gain on bank acquisition, service charges and other fees, merchant Visa income (net), FDIC loss sharing income (net), and other operating income. Noninterest expenses consist primarily of compensation and employee benefits, occupancy and equipment, data processing, professional services and other expenses. Compensation and employee benefits consist primarily of the salaries and wages paid to our employees, payroll taxes, expenses for retirement and other employee benefits. Occupancy and equipment expenses, which are the fixed and variable costs of buildings and equipment, consist primarily of lease payments, taxes, depreciation charges, maintenance and costs of utilities.

Results of operations may also be affected significantly by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.

Net interest income is affected by changes in the volume and mix of interest earning assets, interest earned on those assets, the volume and mix of interest bearing liabilities and interest paid on interest bearing liabilities. Other income and other expenses are impacted by growth of operations and growth in the number of loan and deposit accounts through both acquisitions and core banking business growth. Growth in operations affects other expenses primarily as a result of additional employees, branch facilities and marketing expense. Growth in the number of loan and deposit accounts affects other income, including service charges as well as other expenses such as data processing services, supplies, postage, telecommunications and other miscellaneous expenses.

Earnings Summary

Net income available to shareholders was $0.19 per diluted common share for the three months ended March 31, 2013 compared to $0.27 per diluted common share for the three months ended March 31, 2012. Net income for the three months ended March 31, 2013 was $2.9 million compared to net income of $4.2 million for the same period in 2012. The decrease was primarily the result of a $967,000 increase in the provision for loan losses, a $1.1 million increase in noninterest expense and a $156,000 decrease in net interest income, partially offset by a $374,000 increase in noninterest income. The increase in the noninterest expense is primarily due to the costs related to the NCB Acquisition effective January 9, 2013.


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The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income. The Company's efficiency ratio increased to 72.9% for the three months ended March 31, 2013 from 67.7% for the three months ended March 31, 2012. The increase in the ratio is due to the increase in noninterest expense, mostly as a result of the NCB Acquisition, coupled with the decrease in the net interest income as a result of a decline in net interest margin. While growth strategies are being executed, the Company expects to incur higher expenses as evidenced in the current efficiency ratio. Expenses are expected to be more in line with revenue in the future since these growth strategies are aimed at producing long term results.

Net Interest Income

Net interest income decreased $156,000, or 0.9%, to $16.5 million for the three months ended March 31, 2013, compared with $16.7 million in the same period in 2012. This decrease in net interest income for the three months ended March 31, 2013 was primarily a result of a decrease in the net interest margin. The incremental accretion income related to the loans purchased in the NCB Acquisition was $1.1 million for the three months ended March 31, 2013. Without this incremental accretion from NCB, net interest income would have decreased $1.3 million, or 7.5%, from the same period in 2012. The following table presents the net interest margins and effects of the incremental accretion on purchased loans for the three months ended March 31, 2013 and 2012:

                                                                 Three Months Ended
                                                                      March 31,
                                                                2013              2012
Net interest margin, excluding incremental accretion on
purchased loans (1)                                                4.47 %          4.86 %
Impact on net interest margin from incremental accretion
on purchased loans (1)                                             0.72            0.49

Net interest margin                                                5.19 %          5.35 %

(1) The incremental accretion income represents the amount of income recorded on the purchased loans above the contractual stated interest rate in the individual loan notes. This income stems from the discount established at the time these loan portfolios were acquired and modified as a result of quarterly cash flow re-estimation.

Net interest income as a percentage of average earning assets (net interest margin) for the three months ended March 31, 2013, decreased 16 basis points to 5.19% from 5.35% for the same period in 2012. The decrease in net interest margin for the three months ended March 31, 2013 was primarily due to decreased loan yields partially offset by the decreased costs of interest bearing deposits. The net interest spread for the three months ended March 31, 2013 decreased to 5.07% from 5.20% for the same period in 2012.

The following table provides relevant net interest income information for the dates indicated. The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the tables as loans carrying a zero yield. Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

                                                               For the Three Months Ended March 31,
                                                     2013                                               2012
                                                 Interest                                           Interest
                                   Average        Earned/          Average            Average        Earned/          Average
                                   Balance         Paid         Yield/Rate(1)         Balance         Paid         Yield/Rate(1)
                                                                      (Dollars in thousands)
Interest Earning Assets:
Loans                            $ 1,041,351     $  16,719                6.51 %    $   996,305     $  17,018                6.87 %
Taxable securities                   109,412           373                1.38          121,108           652                2.16
Nontaxable securities                 50,739           335                2.68           34,779           256                2.96
Interest earning deposits and
Federal funds sold                    85,458            57                0.27           96,324            63                0.26
FHLB stock                             5,567            -                   -             5,594            -                   -

Total interest earning assets    $ 1,292,527     $  17,484                5.49 %    $ 1,254,110     $  17,989                5.77 %
Non-interest earning assets          114,107                                            101,698

Total assets                     $ 1,406,634                                        $ 1,355,808


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                                                                  For the Three Months Ended March 31,
                                                        2013                                               2012
                                                    Interest                                           Interest
                                      Average        Earned/          Average            Average        Earned/          Average
                                      Balance         Paid         Yield/Rate(1)         Balance         Paid         Yield/Rate(1)
                                                                         (Dollars in thousands)
Interest Bearing Liabilities:
Certificates of deposit             $   305,342     $     633                0.84 %    $   322,686     $     882                1.10 %
Savings accounts                        128,500            43                0.13          109,129            59                0.22
Interest bearing demand and money
market accounts                         483,421           261                0.22          465,627           336                0.29

Total interest bearing deposits         917,263           937                0.41          897,442         1,277                0.57
Securities sold under agreement
to repurchase                            13,486             9                0.27           19,697            18                0.37

Total interest bearing
liabilities                         $   930,749     $     946                0.41 %    $   917,139     $   1,295                0.57 %

Demand and other non-interest
bearing deposits                        262,967                                            227,970
Other non-interest bearing
liabilities                              12,155                                              5,822
Stockholders' equity                    200,763                                            204,877

Total liabilities and
stockholders' equity                $ 1,406,634                                        $ 1,355,808

Net interest income                                 $  16,538                                          $  16,694

Net interest spread                                                          5.07 %                                             5.20 %
Net interest margin                                                          5.19 %                                             5.35 %
Average interest earning assets
to average interest bearing
liabilities                                                                138.87 %                                           136.74 %

(1) Annualized

Total interest income decreased $505,000, or 2.8%, to $17.5 million for the three months ended March 31, 2013, from $18.0 million for the three months ended March 31, 2012. The decrease in interest income for the three months ended March 31, 2013 was primarily due to lower loan yields and lower investment security yields as a result of the current economic environment.

The balance of average interest earning assets (including nonaccrual loans) increased $38.4 million, or 3.1%, to $1.29 billion for the three months ended March 31, 2013, from $1.25 billion for the three months ended March 31, 2012. The increase in average interest earning assets for the three months ended March 31, 2013 was primarily due to the $51.5 million of loans acquired in the NCB Acquisition on January 9, 2013.

The yield on total interest earning assets decreased 28 basis points from 5.77% for the three months ended March 31, 2012 to 5.49% for the three months ended March 31, 2013. The decrease in the yield on interest earning assets for the three months ended March 31, 2013 reflects the decrease in loan yields and to a lesser extent the decrease in yields on investment securities. The effect of discount accretion on loan yields for the three months ended March 31, 2013 and March 31, 2012 was approximately 90 basis points and 62 basis points, respectively. The increase in discount accretion yield was due to the accretion of the loans purchased in the NCB Acquisition, which generated $1.0 million of interest income for the three months ended March 31, 2013 as a result of shorter-term maturities of the purchased loans and the early payoff of certain significant loans. For the three months ended March 31, 2013 and March 31, 2012, originated nonaccruing loans reduced the yield earned on loans by approximately six basis points and eight basis points, respectively. Originated nonaccrual loans totaled $13.6 million at March 31, 2013 as compared to $12.5 million at December 31, 2012.

Total interest expense decreased by $349,000, or 26.9%, to $946,000 for the three months ended March 31, 2013 from $1.3 million for the three months ended March 31, 2012. The decrease in interest expense was attributable to lower average rates paid on interest bearing liabilities.

The average cost of interest bearing liabilities decreased 16 basis points to 0.41% for the three months ended March 31, 2013 from 0.57% for the three months ended March 31, 2012. Total average interest bearing liabilities increased by $13.6 million, or 1.5%, to $930.7 million for the three months ended March 31, 2013 from $917.1 million for the three months ended March 31, 2012. The increases in average interest bearing liabilities were due primarily to the increase of $40.8 million of interest-bearing deposits assumed in the NCB Acquisition at January 9, 2013 in addition to the increase of approximately $26.8 million in money market deposits added during the quarter due to one customer, which are expected to be withdrawn by the end of 2013. The increase in deposits was offset partially by deposit runoff.


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Deposit interest expense decreased $340,000, or 26.6%, to $937,000 for the three months ended March 31, 2013 compared to $1.3 million for the same quarter in 2012. The decrease in deposit interest expense for the three months ended March 31, 2013 is primarily a result of a 16 basis point decrease in the average cost of interest-bearing deposits, reflecting the low interest rate environment, and to a lesser extent the certificate of deposit runoff.

Provision for Loan Losses

The provision for loan losses for originated loans increased to $495,000 for the three months ended March 31, 2013 from no provision for the three months ended March 31, 2012. The Banks had net charge-offs on originated loans of $1.7 million for the three months ended March 31, 2013 compared to net recoveries of $246,000 for the three months ended March 31, 2012. The charge-offs for the three months ended March 31, 2013 was due primarily to $1.6 million in charge-offs related to one significant borrower who defaulted during the period. Based on the change in mix and volume of the originated loan portfolio at March 31, 2013 compared to December 31, 2012, as well as the decrease in certain historical loss factors and improvements in certain environmental factors, the Company determined that it was appropriate that the provision for loan losses for originated loans for the three months ended March 31, 2013 were lower than the net charge-offs for the same period. The ratio of net charge-offs (recoveries) to average total originated loans outstanding was 0.20% and (.03)% for the three months ended March 31, 2013 and March 31, 2012, respectively.

The Banks have established comprehensive methodologies for determining the allowance for loan losses. On a quarterly basis the Banks perform an analysis taking into consideration pertinent factors underlying the credit quality of the loan portfolio. These factors include changes in the amount and composition of the loan portfolio, historical loss experience for various loan classes, changes in economic conditions, delinquency rates, a detailed analysis of individual loans on nonaccrual status, and other factors to determine the level of the allowance for loan losses. The allowance for loan losses on originated loans decreased by $1.2 million, or 6.3%, to $17.9 million at March 31, 2013 from $19.1 million at December 31, 2012. As of March 31, 2013, the Banks identified $30.2 million of impaired originated loans, which includes $16.6 million of restructured originated performing loans. Of those impaired loans, $15.1 million have no allowances for credit losses as their estimated collateral value is equal to or exceeds their carrying costs. The remaining $15.1 million have related allowances for credit losses totaling $4.9 million.

Based on the comprehensive methodology, management deemed the allowance for loan losses on originated loans of $17.9 million at March 31, 2013 (2.02% of total originated loans and 151.00% of nonperforming originated loans, net of amounts guaranteed by governmental agencies) appropriate to provide for probable incurred losses based on an evaluation of known and inherent risks in the loan portfolio at that date.

The provision for loan losses on purchased loans for the three months ended March 31, 2013 totaled $363,000 compared to a recovery of provision of $109,000 for the three months ended March 31, 2012. The increase in provision expense for the three months ended March 31, 2013 was due substantially to the resolution of a purchased impaired loan to one borrower during the period. Excluding this one transaction, the purchased loans were generally performing in accordance with or better than cash flow estimates from prior periods. As of the acquisition dates, purchased loans were recorded at their estimated fair value, incorporating our estimate of future expected cash flows until the ultimate resolution of these credits. To the extent actual or projected cash flows are less than previously estimated, additional provisions for loan losses on the purchased loan portfolios will be recognized immediately into earnings. To the extent actual or projected cash flows are more than previously estimated, the increase in cash flows is recognized immediately as a recapture of provision for loan losses up to the previously recognized provision for that pool of loans, if any, and then prospectively recognized in interest income as a yield adjustment.

While the Banks believe they have established their existing allowances for loan losses in accordance with GAAP, there can be no assurance that regulators, in reviewing the Banks' loan portfolios, will not request the Banks to increase significantly their allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is appropriate or that increased provisions will not be necessary should the credit quality of the loans deteriorate. Any material increase in the allowance for loan losses would adversely affect the Company's financial condition and results of operations.

Noninterest Income

Total noninterest income increased $374,000, or 19.6%, to $2.3 million for the three months ended March 31, 2013 compared to $1.9 million for the same period in 2012. The increase for the three months ended March 31, 2013 was due substantially to the bargain purchase gain on bank acquisition of $399,000 recorded as a result of the NCB Acquisition. The increase was partially offset by the effects of the reduction in the amount of change in the FDIC indemnification asset. The change in FDIC indemnification asset was a decrease of $267,000 for the three months ended March 31, 2013 compared to a decrease of $176,000 during the same period in 2012.


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Noninterest Expense

Noninterest expense increased $1.1 million, or 8.9%, to $13.7 million during the quarter ended March 31, 2013 compared to $12.6 million for the quarter ended March 31, 2012. The increase for the three months ended March 31, 2013 compared to the same period in 2012 was primarily the result of the following: increased compensation and employee benefits of $391,000; increased data processing of $545,000; increased occupancy and equipment of $135,000 and increased professional services of $476,000; and was partially offset by a $360,000 decrease in other real estate owned, net. The increase in noninterest expense is primarily due to the NCB Acquisition and conversion costs (appearing as data processing and professional service expenses) as well as ongoing additional expenses relating to the NCB Acquisition. The total NCB Acquisition costs incurred during the three months ended March 31, 2013 was approximately $665,000. In addition, the Company incurred expenses of $148,000 during the three months ended March 31, 2013 related to the proposed acquisition of Valley Community Bancshares, which is expected to close during third quarter of 2013.

Income Tax Expense

The provision for income taxes decreased by $585,000, or 30.1%, to $1.4 million for the three months ended March 31, 2013 from $1.9 million for the three months ended March 31, 2012. The Company's effective tax rate was 32.0% for the three months ended March 31, 2013 compared to 31.8% for the same period in 2012. The increase in the Company's effective tax rate for the three months ended March 31, 2013 is due primarily to nondeductible expenses related to the NCB Acquisition and proposed Valley Acquisition.

Financial Condition Data

Total assets were $1.45 billion as of March 31, 2013 as compared to $1.35 billion as of December 31, 2012. The increase was due primarily to increases in cash and cash equivalents of $39.1 million, gross purchased non-covered loans receivable of $45.7, and originated loans receivable of $12.6 million during the three months ended March 31, 2013. The purchased non-covered loans receivable increased as a result of the NCB Acquisition, which had fair value of $51.5 million of loans at the acquisition date and $49.1 million at March 31, 2013.

Deposits increased by $107.1 million, or 9.6%, to $1.23 billion as of March 31, 2013 compared to $1.12 billion as of December 31, 2012. The increase in deposits was due primarily to the $60.4 million of NCB deposits assumed at the acquisition date. In addition, approximately $26.8 million in money market deposits was added during the three months ended March 31, 2013 related to one customer, which are anticipated to be withdrawn by the end of 2013. Securities sold under agreement to repurchase decreased $4.0, or 24.9%, to $12.0 million as of March 31, 2013 from $16.0 million as of December 31, 2012 primarily due to decreases in customer balances. The accrued expenses and other liabilities decreased $3.2 million, or 25.2%, from $12.6 million at December 31, 2012 to $9.4 million at March 31, 2013 due to payment of incentive compensation accrued for in 2012.

Total stockholders' equity increased by $1.6 million, or 0.8%, to $200.5 million as of March 31, 2013 from $198.9 million at December 31, 2012 mostly as a result of net income of $2.9 million partially offset by $1.2 million in cash dividends. The Company's capital position remains strong at 13.9% of total assets as of March 31, 2013 compared to 14.8% at December 31, 2012.

Lending Activities

As indicated in the table below, total loans receivable, net of deferred loan fees (excluding loans held for sale) increased $56.1 million, or 5.5%, to $1.08 billion at March 31, 2013 from $1.03 billion at December 31, 2012. Total originated loans, net of deferred loan fees (excluding loans held for sale) increased $12.6 million, or 1.4%, to $887.1 million at March 31, 2013 from $874.5 million at December 31, 2012.

                                            At              % of                  At                % of
                                        March 31,           Total            December 31,           Total
                                           2013          Originated              2012            Originated
                                                               (Dollars in thousands)
Originated Loans:
Commercial business:
Commercial and industrial               $  269,174              30.4 %      $      277,240              31.7 %
Owner-occupied commercial real
estate                                     193,518              21.8               188,494              21.6
Non-owner occupied commercial real
estate                                     285,963              32.2               265,835              30.4


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                                          At                 % of                  At                  % of
                                       March 31,            Total             December 31,            Total
                                         2013             Originated              2012              Originated
                                                               (Dollars in thousands)
Total commercial business                 748,655                84.4               731,569                83.7
One-to-four family residential
mortgages                                  39,111                 4.4                38,848                 4.4
Real estate construction and land
. . .
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