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HFWA > SEC Filings for HFWA > Form 10-Q on 1-May-2014All Recent SEC Filings

Show all filings for HERITAGE FINANCIAL CORP /WA/

Form 10-Q for HERITAGE FINANCIAL CORP /WA/


1-May-2014

Quarterly Report


ITEM 7. MANGEMENT'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, 2014. The information contained in this section should be read with the unaudited Condensed Consolidated Financial Statements and the accompanying Notes included herein, and the December 31, 2013 audited Consolidated Financial Statements and the accompanying Notes included in our Annual Report on Form 10-K for the year ended December 31, 2013.
Overview
Heritage Financial Corporation is a bank holding company, which primarily engages in the business activities of its wholly owned subsidiary, Heritage Bank. We provide financial services to our local communities with an ongoing strategic focus on expanding our commercial lending relationships and market area and a continual focus on asset quality. At March 31, 2014, we had total assets of $1.66 billion and total stockholders' equity of $216.4 million. The Company's business activities generally are limited to passive investment activities and oversight of its investment in the Bank. Accordingly, the information set forth in this report relates primarily to the Bank's 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 originate real estate construction and land development loans, consumer loans and one-to-four family residential loans collateralized by 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. 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, which is the amount we pay on our interest bearing liabilities, including primarily deposits. 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. Like most financial institutions, our net interest income is affected significantly by general and local economic conditions, particularly changes in market interest rates, and by governmental policies and actions of regulatory agencies. Net interest income is additionally affected by changes on the volume and mix of interest earning assets, interest earned on this assets, the volume and mix of interest bearing liabilities and interest paid on interest bearing liabilities.
Our net income is affected by many factors, including the provision for loan losses. 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.
Net income is also affected by noninterest income and noninterest expense. Noninterest income primarily consists of service charges and other fees, merchant Visa income (net), change in FDIC indemnification asset and other income. Noninterest expense consists 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, governmental policies and actions of regulatory authorities. Other income and other expenses are also impacted by growth of operations and growth in the number of loan and deposit accounts through 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 was $0.16 per diluted common share for the three months ended March 31, 2014 compared to $0.19 per diluted common share for the three months ended March 31, 2013. Net income for the three months ended March 31, 2014 was $2.5 million compared to net income of $2.9 million for the same period in 2013. The $342,000, or 11.9%, decrease was primarily the result of a $1.1 million increase in noninterest expense, partially offset by a $400,000 decrease in total provision for loan losses and a $166,000 increase in net interest income.


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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 77.6% for the three months ended March 31, 2014 from 72.9% for the three months ended March 31, 2013. The increase in the ratio for the three months ended March 31, 2014 is due primarily to the increase in the noninterest expense as a result of the Valley Acquisition and proposed Washington Banking Merger. 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 consistent with revenue in the future since these growth strategies are being implemented to produce long term positive results. The efficiency ratio for the three months ended March 31, 2014 was additionally affected by a trending decline in the net interest margin.

Net Interest Income
One of the Company's key sources of earnings is net interest income. There are several factors that affect net income including, but not limited to, the volume, pricing, mix and maturity of interest-earning assets and interest-bearing liabilities; the volume of noninterest-bearing deposits and other liabilities and shareholders' equity; the volume of noninterest-earning assets; market interest rate fluctuations; and asset quality.
Net interest income increased $166,000, or 1.0%, to $16.7 million for the three months ended March 31, 2014, compared with $16.6 million for the same period in 2013. 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.


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                                                       Three Months Ended March 31,
                                              2014                                      2013
                                              Interest      Average                     Interest      Average
                                Average        Earned/      Yield/        Average        Earned/      Yield/
                                Balance         Paid       Rate (1)       Balance         Paid       Rate (1)
                                                          (Dollars in thousands)
Interest Earning Assets:
Loans, net                   $ 1,205,416     $  16,451        5.53 %   $ 1,041,351     $  16,756        6.53 %
Taxable securities               127,863           639        2.03         106,225           373        1.45
Nontaxable securities             73,096           436        2.42          53,927           335        2.47
Other interest earning
assets                           109,826            87        0.32          91,174            57        0.25
Total interest earning
assets                       $ 1,516,201     $  17,613        4.71 %   $ 1,292,677     $  17,521        5.50 %
Noninterest earning assets       136,693                                   113,957
Total assets                 $ 1,652,894                               $ 1,406,634
Interest Bearing
Liabilities:
Certificates of deposit      $   301,017     $     553        0.75 %   $   305,342     $     633        0.84 %
Savings accounts                 165,911            40        0.10         128,500            43        0.13
Interest bearing demand and
money market accounts            582,300           261        0.18         483,421           261        0.22
Total interest bearing
deposits                       1,049,228           854        0.33         917,263           937        0.41
Securities sold under
agreement to repurchase           27,649            18        0.26          13,486             9        0.28
Total interest bearing
liabilities                  $ 1,076,877     $     872        0.33 %   $   930,749     $     946        0.41 %
Demand and other noninterest
bearing deposits                 343,826                                   262,967
Other noninterest bearing
liabilities                       14,470                                    12,155
Stockholders' equity             217,721                                   200,763
Total liabilities and
stock-holders' equity        $ 1,652,894                               $ 1,406,634
Net interest income                          $  16,741                                 $  16,575
Net interest spread                                           4.38 %                                    5.09 %
Net interest margin                                           4.48 %                                    5.20 %
Average interest earning
assets to average interest
bearing liabilities                                         140.80 %                                  138.89 %

(1) Annualized The $166,000 increase in net interest income for the three months ended March 31, 2014 compared to the same period in 2013 was primarily the result of an increase in the taxable securities and the taxable securities' yields and a decrease in the certificate of deposit balance and yields, partially offset by a decrease in the loan yields. The Company continues to experience lower contractual loan note rates which are partially offset by the decreased costs of interest bearing deposits. The effects of the incremental accretion income have also resulted in a decrease in net interest income. The following table presents the net interest margins and effects of the incremental accretion on purchased loans for the three months ended March 31, 2014 and 2013:

                                                             Three Months Ended March 31,
                                                                2014               2013
Net interest margin, excluding incremental accretion on
purchased loans (1)                                               4.23 %              4.48 %
Impact on net interest margin from incremental accretion
on purchased loans (1)                                            0.25                0.72
Net interest margin                                               4.48 %              5.20 %

(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 results from the discount established at the time these loan portfolios were acquired and modified as a result of quarterly cash flow re-estimation.


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The impact on net interest margin from incremental accretion on purchased loans decreased 47 basis points to 0.25% for the three months ended March 31, 2014 from 0.72% for the same period in 2013 primarily as a result of loans purchased in the NCB Acquisition on January 9, 2013. During the three months ended March 31, 2013, the Bank recorded $1.1 million of incremental income related to NCB purchased loans primarily as a result of unanticipated prepayments of the newly acquired loans, compared to incremental income related to NCB purchased loans of $78,000 for the three months ended March 31, 2014.
Net interest income as a percentage of average earning assets (net interest margin) for the three months ended March 31, 2014, decreased 72 basis points to 4.48% from 5.20% for the same period in 2013. The net interest spread for the three months ended March 31, 2014 decreased 71 basis points to 4.38% from 5.09% for the same period in 2013.
Total interest income increased $92,000, or 0.5%, to $17.6 million for the three months ended March 31, 2014, from $17.5 million for the three months ended March 31, 2013. The increase in interest income for the three months ended March 31, 2014 was primarily due to the $22.4 million, or 21.3%, increase in taxable investment securities as well as the increase in the yield and the related interest income recognized on the taxable investment securities, partially offset by lower contractual loan yields.
The balance of average interest earning assets (including nonaccrual loans) increased $223.5 million, or 17.3%, to $1.52 billion for the three months ended March 31, 2014, from $1.29 billion for the three months ended March 31, 2013 primarily due to the Valley Acquisition on July 15, 2013. The Bank acquired fair value of $117.1 million in loans, $13.9 million in other interest earning deposits and $54.4 million in investment securities in the Valley Acquisition. The average interest earning assets for the three months ended March 31, 2013 was impacted by the fair value of $51.5 million in non-covered loans, $2.8 million in investment securities and $1.0 million in other interest earning deposits acquired in the NCB Acquisition on January 9, 2013. The average originated loans receivable, net increased $129.5 million, or 14.8%, during the three months ended March 31, 2014 to $1.00 billion from $873.7 million for the three months ended March 31, 2013.
The yield on total interest earning assets decreased 79 basis points to 4.71% for the three months ended March 31, 2014 from 5.50% for the three months ended March 31, 2013. The decrease in the yield on interest earning assets for the three months ended March 31, 2014 reflects the decrease in loan yields as a result of lower contractual loan rates and declining effects of discount accretion on loan yields, partially offset by an increase in the yield for the taxable investment securities. The effect of discount accretion on loan yields for the three months ended March 31, 2014 and March 31, 2013 was approximately 31 basis points and 90 basis points, respectively. The decrease in discount accretion yield for the three months ended March 31, 2014 as compared to the same period in 2013 was due to early payoffs of certain NCB purchased loans during the three months ended March 31, 2013. For the three months ended March 31, 2014 and March 31, 2013, nonaccruing originated loans reduced the yield earned on loans by approximately five basis points and seven basis points, respectively. Originated nonaccrual loans totaled $10.6 million at March 31, 2014 as compared to $6.9 million at December 31, 2013 and $13.6 million at March 31, 2013.
Total interest expense decreased by $74,000, or 7.8%, to $872,000 for the three months ended March 31, 2014 from $946,000 for the three months ended March 31, 2013. The decrease in interest expense was attributable to lower average rates paid on interest bearing liabilities, partially offset by higher average interest bearing liabilities.
The average cost of interest bearing liabilities decreased eight basis points to 0.33% for the three months ended March 31, 2014 from 0.41% for the three months ended March 31, 2013. Total average interest bearing liabilities increased by $146.1 million, or 15.7%, to $1.08 billion for the three months ended March 31, 2014 from $930.7 million for the three months ended March 31, 2013. The increase in average interest bearing liabilities for the three months ended March 31, 2014 was due primarily to the Valley Acquisition on July 15, 2013 which had approximately $161.0 million of assumed interest bearing deposits. The NCB Acquisition on January 9, 2013 had approximately $40.8 million of interest bearing deposits which was considered in the average interest bearing liabilities for the three months ended March 31, 2013. Additionally, average interest bearing liabilities increased during the three months ended March 31, 2013 as a result of $26.8 million in non-maturity deposits from one customer which were deposited in first quarter 2013 and were all withdrawn by the end of 2013. These increases in deposits were offset partially by deposit runoff. Deposit interest expense decreased $83,000, or 8.9%, to $854,000 for the three months ended March 31, 2014 compared to $937,000 for the same quarter in 2013. The decrease in deposit interest expense for the three months ended March 31, 2014 is primarily a result of an eight basis point decrease in the average cost of interest bearing deposits.
Due to the current low interest rate environment, together with the projected principal reduction in higher yielding purchased loans, the Bank expects the net interest margin will continue to decline in future periods.


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Provision for Loan Losses
The provision for loan losses is highly dependent on the Company's ability to manage asset quality and control the level of net charge-offs through prudent underwriting standards. In addition, the decline in general economic conditions could increase future provisions for loan losses and materially impact the Company's net income.
The provision for loan losses for originated loans decreased $295,000, or 59.6%, to $200,000 for the three months ended March 31, 2014 from $495,000 for the three months ended March 31, 2013. The amount of the provision was calculated in accordance with the Company's methodology for determining the allowance for loan losses as discussed below. The Bank had net recoveries on originated loans of $181,000 for the three months ended March 31, 2014 compared to net charge-off $1.7 million for the three months ended March 31, 2013.
Based on the change in mix and volume of the originated loan portfolio at March 31, 2014 compared to December 31, 2013, as well as the decrease in certain historical loss factors and improvements in certain environmental factors, the Company determined that the provision for loan losses for originated loans of $200,000 for the three months ended March 31, 2014 was appropriate. The ratio of net (recoveries) charge-offs to average total originated loans outstanding was (0.02%) for the three months ended March 31, 2014 compared to 0.20% for the three months ended March 31, 2013.
The Bank has established a comprehensive methodology for determining the allowance for loan losses. On a quarterly basis, the Bank performs 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 increased by $381,000, or 2.2%, to $17.5 million at March 31, 2014 from $17.2 million at December 31, 2013. As of March 31, 2014, the Bank identified $29.3 million of impaired originated loans, which includes $18.7 million of performing restructured originated loans. Of those impaired loans, $16.3 million have no allowances for credit losses as their estimated collateral value is equal to or exceeds their carrying costs. The remaining $13.1 million have related allowances for credit losses totaling $3.5 million.
Based on the established comprehensive methodology, management deemed the allowance for loan losses on originated loans of $17.5 million at March 31, 2014 (1.76% of total originated loans and 199.15% 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 following table outlines the allowance for loan losses on originated loans and related outstanding loan balances at March 31, 2014 and December 31, 2013:

                                                     March 31, 2014      December 31, 2013
                                                            (Dollars in thousands)
General Valuation Allowance:
Allowance for loan losses on originated loans       $        14,010     $          14,054
Gross originated loan balance of non-impaired loans         967,197               952,569
Percentage                                                     1.45 %                1.48 %

Specific Valuation Allowance:
Allowance for loan losses on originated loans       $         3,524     $           3,099
Gross originated loan balance of impaired loans              29,336                27,386
Percentage                                                    12.01 %               11.32 %

Total Allowance for Loan Losses:
Allowance for loan losses on originated loans       $        17,534     $          17,153
Gross originated loan balance                               996,533               979,955
Percentage                                                     1.76 %                1.75 %

The Bank has established a comprehensive methodology for determining the allowance for loan losses on the purchased other loans which is similar to the methodology for the originated loans receivable with the additional consideration of the remaining fair value discount, if any, on the loans, estimated at the acquisition date. For the purchased impaired loans, the acquisition date fair value incorporated our estimate of future expected cash flows until


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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.
The provision for loan losses on purchased loans for the three months ended March 31, 2014 totaled $258,000, a decrease of $105,000, or 28.9%, compared to $363,000 for the three months ended March 31, 2013. The provision expense for the three months ended March 31, 2014 was due substantially to one borrower who experienced financial difficulties during the period and whose collateral decreased in value. The need for a greater provision expense was partially offset by purchased impaired loans that experienced cash flows that were better than expected for the prior period, which generated a reversal of a portion of the previously recorded allowance for loan losses for certain pools. Excluding the identified transaction, the purchased loans were generally performing in accordance with or better than cash flow estimates from prior periods. During the three months ended March 31, 2013, the provision for loan losses reflected the resolution of a purchased impaired loan to one borrower.
While the Bank believes it has established its existing allowances for loan losses in accordance with GAAP, there can be no assurance that bank regulators, in reviewing the Bank's loan portfolio, will not request the Bank to increase significantly its 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 $62,000, or 2.8%, to $2.3 million for the
three months ended March 31, 2014 compared to $2.2 million for the same period
in 2013. The following table presents the key components of noninterest income
for the three months ended March 31, 2014 and the change from the comparable
quarter in 2013.
                                              Three Months Ended March 31,
                                                 2014               2013           Change      Percentage Change
                                                                   (Dollars in thousands)
Bargain purchase gain on bank acquisition  $           -       $         399     $   (399 )          (100.0 )%
Service charges and other fees                     1,398               1,353           45               3.3
Merchant Visa income, net                            245                 172           73              42.4
Change in FDIC indemnification asset                 (37 )              (267 )        230              86.1
Gain on sale of investment securities, net           180                   -          180             100.0
Other income                                         521                 588          (67 )           (11.4 )
Total noninterest income                   $       2,307       $       2,245     $     62               2.8  %

The change in FDIC indemnification asset caption includes amortization of the FDIC indemnification asset and increases to the FDIC indemnification asset as a result of decreases in projected remaining cash flows of the purchased covered loans. The increase in the Change in FDIC indemnification asset was primarily due to a $248,000 increase in the FDIC share of additional estimated losses as a result of the collateral deterioration of one loan during the three months ended March 31, 2014, which also caused the increase in the provision for loan losses for the same period. Under the symmetrical accounting for acquired covered loans, an increase in the provision for loan losses on covered loans will generally have a related increase in the FDIC share of additional estimated losses. The provision for loan losses on covered loans was $479,000 for the three months ended March 31, 2014 and increase of $121,000, or 33.8%, compared to $358,000 for the three months ended March 31, 2013.
The bargain purchase gain on bank acquisition of $399,000 for the three months ended March 31, 2013 was the result of the NCB Acquisition in January 2013. There were no acquisitions for the three months ended March 31, 2014.


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Noninterest Expense
Noninterest expense increased $1.1 million, or 7.7%, to $14.8 million during the
three months ended March 31, 2014 compared to $13.7 million for the three months
ended March 31, 2013. The following table presents the key components of
noninterest expense for the three months ended March 31, 2014 and the change
from the comparable quarter in 2013.
. . .
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