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HFWA > SEC Filings for HFWA > Form 10-Q on 8-Aug-2014All Recent SEC Filings

Show all filings for HERITAGE FINANCIAL CORP /WA/

Form 10-Q for HERITAGE FINANCIAL CORP /WA/


8-Aug-2014

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 and six months ended June 30, 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 June 30, 2014, we had total assets of $3.39 billion and total stockholders' equity of $449.8 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 these 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.

Recent Developments
We successfully completed the Washington Banking Merger on May 1, 2014. See "Note 2. Business Combination" for details of the transaction and events that comprised the Washington Banking Merger. Legacy Washington Banking results since May 1, 2014 are included in the results from operations in this Report on Form 10-Q; therefore, the results included in this Report on Form 10-Q for the six months ended June 30, 2014 include two months of operations of legacy Washington Banking and six months of operations of the Company.


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The Washington Banking Merger is consistent with our strategy of expanding our footprint along the I-5 corridor. We believe the Washington Banking Merger creates a more efficient organization by combining two culturally similar commercial banks. We anticipate the Washington Banking Merger will provide additional lending opportunities, increase our ability to gather and maintain low cost core deposits, generate substantial cost savings and create revenue enhancing opportunities.
As of June 30, 2014 the Company had 67 branching locations. The Company intends to continue executing its lending practices across the newly expanded market area. We will focus on commercial and consumer lending, including increased Small Business lending. In addition, the Washington Banking Merger provides us with a greater, more diversified non-interest income stream through increased mortgage banking and SBA lending operations.
In connection with the Washington Banking Merger, we announced a target of achieving cost savings of approximately 10% of the combined Company's noninterest expense. Cost savings resulting from the Washington Banking Merger will occur primarily through reductions in combined staffing levels and elimination of duplicate processes and third-party services. The cost savings are not expected to be fully realized until subsequent to the core system conversion which is anticipated to occur in the fourth quarter of 2014. Results of operations for the three months and six months ended June 30, 2014 were significantly impacted by the costs associated with the Washington Banking Merger. For the three months and six months ended June 30, 2014, the Company incurred Washington Banking merger-related expenses of $5.3 million and $5.6 million, respectively. These expenses were primarily professional advisory fees, legal fees and contract termination fees.

Earnings Summary
Net income was $0.16 per diluted common share for the three months ended June 30, 2014 compared to $0.18 per diluted common share for the three months ended June 30, 2013. Net income for the three months ended June 30, 2014 was $4.1 million compared to net income of $2.7 million for the same period in 2013. Net income was $0.32 per diluted common share for the six months ended June 30, 2014 compared to $0.37 per diluted common share for the six months ended June 30, 2013. Net income for the six months ended June 30, 2014 was $6.7 million compared to net income of $5.6 million for the same period in 2013. The $1.5 million, or 54.2% increase in net income for the three months ended June 30, 2014 was primarily the result of the Washington Banking Merger, as well as a $617,000, or 47.2%, decrease in the total provision for loan losses. The $1.1 million, or 20.0%, increase in net income for the six months ended June 30, 2014 was primarily the result of the Washington Banking Merger as well as a $1.0 million decrease in the total provision for loan losses.
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 80.9% for the three months ended June 30, 2014 from 71.1% for the three months ended June 30, 2013. The Company's efficiency ratio increased to 79.7% for the six months ended June 30, 2014 from 72.0% for the six months ended June 30, 2013. The increase in the ratio for the three and six months ended June 30, 2014 is due primarily to the $14.0 million and $15.0 million, respectively, increase in noninterest expense as a result of the Washington Banking Merger. While growth strategies are being executed, the Company expects to incur higher expenses as evidenced in the current efficiency ratio until such time the cost savings are realized. 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 and six months ended June 30, 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 $12.7 million, or 79.4%, to $28.6 million for the three months ended June 30, 2014, compared to $15.9 million for the same period in 2013. Net interest income increased $12.9 million, or 39.6%, to $45.3 million for the six months ended June 30, 2014, compared with $32.5 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 June 30,
                                              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                   $ 1,878,496     $  27,446        5.86 %   $ 1,065,465     $  16,028        6.03 %
Taxable securities               343,571         1,812        2.11         105,687           404        1.53
Nontaxable securities            131,230           638        1.95          57,109           345        2.42
Other interest earning
assets                           170,087           127        0.30          97,425            82        0.34
Total interest earning
assets                       $ 2,523,384     $  30,023        4.77 %   $ 1,325,686     $  16,859        5.10 %
Noninterest earning assets       290,048                                   111,293
Total assets                 $ 2,813,432                               $ 1,436,979
Interest Bearing
Liabilities:
Certificates of deposit      $   520,269     $     777        0.60 %   $   292,781     $     614        0.84 %
Savings accounts                 241,461            52        0.09         134,697            42        0.13
Interest bearing demand and
money market accounts          1,059,953           468        0.18         511,049           253        0.20
Total interest bearing
deposits                       1,821,683         1,297        0.29         938,527           909        0.39
FHLB advances and other
borrowings                           439             -        0.29               1             -        0.75
Securities sold under
agreement to repurchase           24,409            15        0.26          14,831            10        0.26
Junior subordinated
debentures                        12,694           115        3.62               -             -           -
Total interest bearing
liabilities                  $ 1,859,225     $   1,427        0.31 %   $   953,359     $     919        0.39 %
Demand and other noninterest
bearing deposits                 553,284                                   273,307
Other noninterest bearing
liabilities                       30,259                                     7,942
Stockholders' equity             370,664                                   202,371
Total liabilities and
stockholders' equity         $ 2,813,432                               $ 1,436,979
Net interest income                          $  28,596                                 $  15,940
Net interest spread                                           4.46 %                                    4.71 %
Net interest margin                                           4.55 %                                    4.82 %
Average interest earning
assets to average interest
bearing liabilities                                         135.72 %                                  139.05 %

(1) Annualized


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                                                          Six Months Ended June 30, 2014
                                                  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                       $ 1,543,815     $  43,897        5.73 %   $ 1,053,475     $  32,747        6.27 %
Taxable securities                   236,313         2,451        2.09         105,955           777        1.48
Nontaxable securities                102,324         1,074        2.12          55,526           680        2.47
Other interest earning assets        140,123           214        0.31          94,317           139        0.30
Total interest earning assets    $ 2,022,575     $  47,636        4.75 %   $ 1,309,273     $  34,343        5.29 %
Noninterest earning assets           213,794                                   112,617
Total assets                     $ 2,236,369                               $ 1,421,890
Interest Bearing Liabilities:
Certificates of deposit          $   411,248     $   1,330        0.65 %   $   299,027     $   1,247        0.84 %
Savings accounts                     209,284            92        0.09         131,616            85        0.13
Interest bearing demand and
money market accounts                817,057           729        0.18         497,311           515        0.21
Total interest bearing deposits    1,437,589         2,151        0.30         927,954         1,847        0.40
FHLB advances and other
borrowings                               221             -        0.30               1             -        0.75
Securities sold under agreement
to repurchase                         26,020            33        0.26          14,162            19        0.27
Junior subordinated debentures         6,382           115        3.62               -             -           -
Total interest bearing
liabilities                      $ 1,470,212     $   2,299        0.32 %   $   942,117     $   1,866        0.40 %
Demand and other noninterest
bearing deposits                     449,134                                   268,166
Other noninterest bearing
liabilities                           22,408                                    10,036
Stockholders' equity                 294,615                                   201,571
Total liabilities and
stockholders' equity             $ 2,236,369                               $ 1,421,890
Net interest income                              $  45,337                                 $  32,477
Net interest spread                                               4.43 %                                    4.89 %
Net interest margin                                               4.52 %                                    5.00 %
Average interest earning assets
to average interest bearing
liabilities                                                     137.57 %                                  138.97 %

(1) Annualized

The $12.7 million increase in net interest income for the three months ended June 30, 2014 compared to the same period in 2013 and the $12.9 million increase in the net interest income for the six months ended June 30, 2014 compared to the same period in 2013 was primarily the result of an increase in the interest and fees on loans as a result of the Washington Banking Merger. The average loans receivable for the six months ended June 30, 2014 was $1.54 billion compared to $1.05 billion for the six months ended June 30, 2013. A decrease in the contractual loan note rates caused the yield to decrease to 5.73% for the six months ended June 30, 2014 as compared to 6.27% for the same period in 2013, which partially offset the increase in the interest income on loans. The taxable securities and nontaxable securities' average balances increased as a result of the Washington Banking Merger, which also caused an increase in interest income earned on the securities. The yield increased on the taxable securities to 2.09% for the six months ended June 30, 2014 from 1.48% for the same period in 2013 and partially contributed to the increase in interest income. Although the average balance of interest bearing deposits increased $509.6 million, or 54.9%, to $1.44 billion for the six months ended June 30, 2014 from $928.0 million for the six months ended June 30, 2013, a decrease in the average rates to 0.30% from 0.40%, respectively, meant the interest expense on deposits only increased $304,000, or 16.5%, for the six months ended June 30, 2014. In connection with the Washington Banking Merger, the Company acquired junior subordinated debentures of Washington Banking. The average rate of these debentures for the three and six months ended June 30, 2014 was 3.62%. The effects of the incremental accretion income have also resulted in an increase in net interest income for the three months ended June 30, 2014 as compared to the three months ended June 30, 2013.


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Net interest income as a percentage of average earning assets (net interest margin) for the three months ended June 30, 2014, decreased 27 basis points to 4.55% from 4.82% for the same period in 2013. The net interest margin for the six months ended June 30, 2014 decreased 48 basis points to 4.52% from 5.00% for the same period in 2013. The net interest spread for the three months ended June 30, 2014 decreased 25 basis points to 4.46% from 4.71% for the same period in 2013. The net interest spread decreased 46 basis points for the six months ended June 30, 2014 to 4.43% from 4.89% for the six months ended June 30, 2013. The following table presents the net interest margins and effects of the incremental accretion on purchased loans for the three and six months ended June 30, 2014 and 2013:

                                                   Three Months Ended June 30,        Six Months Ended June 30,
                                                      2014              2013            2014              2013
Net interest margin, excluding incremental
accretion on purchased loans (1)                       4.12 %             4.37 %         4.15 %             4.42 %
Impact on net interest margin from incremental
accretion on purchased loans (1)                       0.43               0.45           0.37               0.58
Net interest margin                                    4.55 %             4.82 %         4.52 %             5.00 %

(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. The impact on net interest margin from incremental accretion on purchased loans decreased two basis points to 0.43% for the three months ended June 30, 2014 from 0.45% for the same period in 2013. While the dollar amount of incremental income increased to $2.7 million for the three months ended June 30, 2014 compared to $1.5 million for the three months ended June 30, 2013, the percentage impact decreased primarily as a result of an increase in the contractual interest income from the Washington Banking Merger. During the three and six months ended June 30, 2014, the Bank recorded $1.8 million of incremental income related to loans acquired in the Washington Banking Merger, primarily as a result of unanticipated prepayments of the newly acquired loans. Total interest income increased $13.2 million, or 78.1%, to $30.0 million for the three months ended June 30, 2014, from $16.9 million for the three months ended June 30, 2013. Total interest income increased $13.3 million, or 38.7%, to $47.6 million for the six months end June 30, 2014 compared to $34.3 million for the same period in 2013. The increase in interest income for the three and six months ended June 30, 2014 was primarily due to the increase in interest and fees on loans as a result of the Washington Banking Merger. The increase in interest income on loans was partially offset by the decrease in the loans yields as a result of lower contractual note rates as a result of the lower interest rate environment. The balance of average interest earning assets (including nonaccrual loans) increased $1.20 billion, or 90.3%, to $2.52 billion for the three months ended June 30, 2014, from $1.33 billion for the three months ended June 30, 2013. The balance of average interest earning assets (including nonaccrual loans) increased $713.3 million, or 54.5%, to $2.02 billion for the six months ended June 30, 2014, from $1.31 billion for the six months ended June 30, 2013. The increase in average interest earning assets for the three and six months ended June 30, 2014 is primarily due to the Washington Banking Merger. The Bank acquired $1.00 billion of fair value in loans and $458.3 million of fair value in investment securities in the Washington Banking Merger. The average loans receivable, net increased $813.0 million, or 76.3%, and $490.3 million, or 46.5%, during the three and six months ended June 30, 2014, respectively, as compared to the same periods in 2013. The yield on total interest earning assets decreased 33 basis points to 4.77% for the three months ended June 30, 2014 from 5.10% for the three months ended June 30, 2013. The yield on total interest earning assets decreased 54 basis points to 4.75% for the six months ended June 30, 2014 from 5.29% for the six months ended June 30, 2013. The decrease in the yield on interest earning assets for the three and six months ended June 30, 2014 reflects the decrease in loan yields as a result of lower contractual loan rates from the lower interest rate environment. The Bank had also been experiencing a decline in the effects of discount accretion on loan yields until the Washington Banking Merger was completed. Without the effects of the Washington Banking Merger, the effect of the discount accretion on the loan yield would have decreased 36 basis points to 20 basis points for the three months ended June 30, 2014 compared to 56 basis points for the three months ended June 30, 2013. The effect of discount accretion on loan yields for the three months ended June 30, 2014 and June 30, 2013 was approximately 58 basis points and 56 basis points, respectively. The effect of discount accretion on loan yields for the six months ended June 30, 2014 and June 30, 2013 was approximately 48 basis points and 73 basis points, respectively. For the three months ended June 30, 2014 and June 30, 2013, noncovered nonaccrual loans reduced the yield earned on loans by approximately five basis points


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and six basis points, respectively. For the six months ended June 30, 2014 and June 30, 2013, noncovered nonaccrual loans reduced the yield earned on loans by approximately five basis points and seven basis points, respectively. Noncovered nonaccrual loans totaled $13.6 million at June 30, 2014 as compared to $7.7 million at December 31, 2013 and $12.6 million at June 30, 2013.
Total interest expense increased by $508,000, or 55.3%, to $1.4 million for the three months ended June 30, 2014 from $919,000 for the three months ended June 30, 2013. Total interest expense increased $433,000, or 23.2% to $2.3 million for the six months ended June 30, 2014 from $1.9 million for the same period in 2013. The increase in interest expense was attributable to the combination of higher average interest bearing liability balances, primarily as a result of the Washington Banking Merger, offset by lower average rates paid on those interest bearing liabilities.
The average cost of interest bearing liabilities decreased eight basis points to 0.31% for the three months ended June 30, 2014 from 0.39% for the three months ended June 30, 2013. The average cost of interest bearing liabilities decreased eight basis points to 0.32% for the six months ended June 30, 2014 from 0.40% for the same period in 2013. Total average interest bearing liabilities increased by $905.9 million, or 95.0%, to $1.86 billion for the three months ended June 30, 2014 from $953.4 million for the three months ended June 30, 2013. Total average interest bearing liabilities increased by $528.1 million, or 56.1%, to $1.47 billion for the six months ended June 30, 2014 from $942.1 million for the same period in 2013. The increase in average interest bearing liabilities for the three and six months ended June 30, 2014 was due primarily to the Washington Banking Merger which had approximately $1.43 billion in fair value of assumed interest bearing deposits and $18.9 million in fair value of assumed junior subordinated debentures.
Deposit interest expense increased $388,000, or 42.7%, to $1.3 million for the three months ended June 30, 2014 compared to $909,000 for the same quarter in 2013. The deposit interest expense increased $304,000, or 16.5%, to $2.2 million for the six months ended June 30, 2014 compared to $1.8 million for the same period in 2013. The increase in deposit interest expense for the three and six months ended June 30, 2014 is primarily a result of the increase in the average deposit balance, offset partially by a decreased in the deposit average rate to 0.30% for the six months ended June 30, 2014 from 0.40% for the same period in 2013. The increase in the average deposit balances for the three and six months ended June 30, 2014 is primarily the result of the Washington Banking Merger. 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.

Provision for Loan Losses
The provision for loan losses is highly dependent on the Company's ability to . . .

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