Heritage Financial Announces Fourth Quarter And Annual Results And Declares Regular Cash Dividend

OLYMPIA, Wash., Jan. 29, 2015 /PRNewswire/ -- HERITAGE FINANCIAL CORPORATION (NASDAQ GS: HFWA) Brian L. Vance, President and CEO of Heritage Financial Corporation ("Company" or "Heritage"), today reported that the Company had net income of $7.3 million for the quarter ended December 31, 2014 compared to net income of $710,000 for the quarter ended December 31, 2013 and $7.1 million for the linked-quarter ended September 30, 2014.  Net income for the quarter ended December 31, 2014 was $0.24 per diluted common share compared to $0.04 per diluted common share for the quarter ended December 31, 2013 and $0.23 per diluted common share for the linked-quarter ended September 30, 2014.

Net income for the year ended December 31, 2014 was $21.0 million, or $0.82 per diluted common share, compared to $9.6 million, or $0.61 per diluted common share, for the year ended December 31, 2013. 

Mr. Vance commented, "As we have finished our second full quarter following our merger with Washington Banking Company, we are pleased with our overall performance.  We completed a successful systems conversion early in the quarter and also posted strong loan and core deposit growth.  We believe the fourth quarter loan and core deposit growth, especially still early in the consolidation process, is evidence our merger is progressing nicely."

"Although the fourth quarter continued to show merger related expenses, we believe we continue to make significant improvement in cost savings, efficiencies and overall economies of scale.  For the quarter ended December 31, 2014, our earnings per share, return on average assets and return on average equity are all improved over the past five quarters.  In addition, we continue to see improvement in our overall loan quality as evidenced by the reduction of nonperforming noncovered loans to only 0.29% of total noncovered assets."

"Finally, we are also pleased to announce a regular cash dividend of $0.10, which is an 11% increase from the prior quarter regular dividend and a 25% increase from the regular dividend declared a year ago in January 2014."

Merger with Washington Banking Company

Effective May 1, 2014, Heritage completed the strategic merger with Washington Banking Company and its wholly owned subsidiary, Whidbey Island Bank ("Washington Banking Merger").  The merger was accounted for using the acquisition method of accounting. Accordingly, Heritage's cost to acquire Washington Banking was allocated to the assets (including identifiable intangible assets) and the liabilities of Washington Banking at their respective estimated fair values as of the merger date. The excess of the purchase price over the fair value of the net assets acquired was allocated to goodwill.  The fair value on the merger date represents management's best estimates based on available information and facts and circumstances in existence on the merger date. The allocation of the purchase price is subject to adjustment within the one year re-measurement period.

The amount of goodwill recognized from the merger was $90.2 million at December 31, 2014.  The following table provides detail of the fair value of the assets acquired and liabilities assumed:

Impact of 2013 Initiatives

In addition to the merger with Washington Banking, the following other 2013 initiatives had an impact on the Company's 2014 and 2013 operating results:

• On January 9, 2013, the Company acquired Northwest Commercial Bank ("NCB") and merged it into Heritage Bank, the Company's subsidiary bank (the "NCB Acquisition"). NCB was a full service commercial bank with branches in Lakewood and Auburn, Washington.  In March 2013, the Company consolidated the operations of the former NCB Lakewood branch with the Lakewood branch of Heritage Bank. 
• On June 19, 2013, the Company completed the merger of its subsidiary, Central Valley Bank ("CVB"), with and into Heritage Bank (the "CVB Merger").  CVB is now operated as a division of Heritage Bank. 
• On July 15, 2013, the Company completed the acquisition of Valley Community Bancshares, Inc. ("Valley"), the holding company for Valley Bank, both of Puyallup, Washington (the "Valley Acquisition").  As of the acquisition date, Valley merged into Heritage and Valley Bank merged into Heritage Bank.  During the quarter ended December 31, 2013, four former Valley Bank branches were consolidated into existing Heritage Bank branches.
• During the quarter ended December 31, 2013, the Company completed a core system conversion of Heritage Bank.
• Also during the quarter ended December 31, 2013, the Company consolidated three Heritage Bank branches into existing Heritage Bank branches.

Balance Sheet

The Company's total assets increased $8.6 million to $3.46 billion at December 31, 2014 from $3.45 billion at September 30, 2014.  Although total assets increased only modestly, there was a change in the mix of assets during the quarter ended December 31, 2014.  As a percentage of total assets, total loans receivable, net of allowance for loan losses, and investment securities increased to 64.3% and 22.5%, respectively at December 31, 2014 from 63.0% and 20.9%, respectively, at September 30, 2014 while interest earning deposits decreased to 1.4% of total assets at December 31, 2014 from 4.2% at September 30, 2014.

Total loans receivable, net of allowance for loan losses, increased $48.8 million to $2.22 billion at December 31, 2014 from $2.17 billion at September 30, 2014.  The increase was due to an increase of $60.9 million in noncovered loans receivable, net of allowance for loan losses, to $2.10 billion at December 31, 2014 from $2.04 billion at September 30, 2014.  Noncovered loans include loans originated by Heritage Bank as well as other noncovered loans obtained in mergers and acquisitions.  This increase was partially offset by a decrease of $12.1 million in covered loans receivable, net of allowance for loan losses, to $120.6 million at December 31, 2014 from $132.7 million at September 30, 2014.  Covered loans are loans acquired through FDIC-assisted transactions which are covered by FDIC shared-loss agreements.  These balances are expected to continue to decline substantially over the next few quarters. 

Jeffrey J. Deuel, President & Chief Operating Officer of Heritage Bank, commented, "As anticipated we saw much stronger loan production in the fourth quarter with a large portion of new loans closing in December. New loan production occurred across a broad cross section of loan classes and also included some larger transactions. We are also seeing a continuing positive trend in noninterest bearing demand deposits which offsets the decline in certificates of deposit.  Now that the most difficult aspects of the October 2014 system conversion are behind us we are now focused on refining processes and finding ways to leverage our footprint and the combined product lines."

Total deposits increased $3.3 million to $2.91 billion at December 31, 2014 from $2.90 billion at September 30, 2014.  Non-maturity deposits as a percentage of total deposits increased to 81.9% at December 31, 2014 from 80.1% at September 30, 2014, which included noninterest bearing demand deposits that increased to 24.4% of total deposits at December 31, 2014 from 23.9% of total deposits at September 30, 2014.  The increases in these ratios were primarily due to a $52.5 million decrease in certificates of deposits to $525.4 million as of December 31, 2014 from $577.9 million as of September 30, 2014. 

Total stockholders' equity increased $3.3 million to $455.0 million at December 31, 2014 from $451.7 million at September 30, 2014.  This increase was due to net income of $7.3 million and an increase of $3.4 million in accumulated other comprehensive income, net for the quarter ended December 31, 2014, partially offset by cash dividends of $7.5 million.  The Company and Heritage Bank continue to maintain capital levels significantly in excess of the applicable regulatory requirements for them to be categorized as "well-capitalized". The Company had Tier 1 leverage, Tier 1 risk-based and total risk-based capital ratios at December 31, 2014 of 10.3%, 13.9% and 15.1%, respectively, as compared to 10.3%, 14.7%, and 15.9%, respectively, at September 30, 2014. 

Credit Quality

The allowance for loan losses on noncovered loans decreased $67,000 to $22.15 million at December 31, 2014 from $22.22 million at September 30, 2014 as a result of $1.4 million in net charge-offs recognized during the quarter ended December 31, 2014 partially offset by $1.3 million in provision for loan losses.  Nonperforming noncovered loans to total noncovered loans decreased to 0.35% at December 31, 2014 from 0.57% at September 30, 2014.  Nonaccrual noncovered loans decreased $4.2 million to $7.5 million ($1.6 million guaranteed by government agencies) at December 31, 2014 from $11.7 million ($1.8 million guaranteed by government agencies) at September 30, 2014.  The decrease was due to $5.6 million of net principal reductions, $640,000 of charge-offs and $322,000 of transfers to accrual status, offset partially by $2.4 million of additions to nonaccrual noncovered loans.

The allowance for loan losses to nonperforming noncovered loans was 294.98% at December 31, 2014 compared to 190.35% at September 30, 2014.  Potential problem noncovered loans were $117.3 million at December 31, 2014 compared to $125.4 million at September 30, 2014. The $8.2 million decrease was primarily due to net loan payments of $23.7 million and net transfers of $690,000 to nonaccrual status, offset partially by the addition of $16.2 million of loans graded as potential problem loans during the period.

The allowance for loan losses on noncovered loans to total noncovered loans, net was 1.04% at December 31, 2014 and 1.08% at September 30, 2014.  The Company believes that its allowance for loan losses is appropriate to provide for probable incurred credit losses based on an evaluation of known and inherent risks in the loan portfolio at December 31, 2014. Included in the carrying value of noncovered loans are net discounts remaining from mergers and acquisitions which would be utilized if there were principal losses on related loans.  The remaining net discounts on noncovered loans at December 31, 2014 were $24.0 million.

Nonperforming noncovered assets were $9.7 million ($1.6 million guaranteed by government agencies), or 0.29% of total noncovered assets, at December 31, 2014, compared to $15.8 million ($1.8 million guaranteed by government agencies), or 0.48% of total noncovered assets, at September 30, 2014.  Other real estate owned decreased $3.5 to $3.4 million at December 31, 2014 (of which $1.2 million was covered by FDIC shared-loss agreements) from $6.9 million at September 30, 2014 (of which $2.8 million was covered by FDIC shared-loss agreements).  During the quarter ended December 31, 2014, the Company sold 10 properties resulting in proceeds of $4.7 million and a net gain of $335,000.

Operating Results

Net interest income increased $19.1 million to $36.8 million for the quarter ended December 31, 2014 compared to $17.6 million for the same period in 2013.  Net interest income increased $47.7 million to $115.4 million for the year ended December 31, 2014 compared to $67.7 million for the prior year.  The increases in net interest income are primarily due to the Washington Banking Merger.

Heritage's net interest margin for the quarter ended December 31, 2014 increased 16 basis points to 4.74% from 4.58% for the same period in 2013 and increased 42 basis points from 4.32% in the linked-quarter ended September 30, 2014.  The increase in net interest margin from prior periods is primarily due to the increase in incremental interest income as a result of the Washington Banking loans during the quarter ended December 31, 2014.  Heritage's net interest margin for the year ended December 31, 2014 decreased 27 basis points to 4.53% from 4.80% for the prior year due primarily to lower contractual interest rates on loans and a change in the mix of interest earning assets. 

The following table presents the net interest margin and effect of the incremental accretion on purchased loans for the periods presented below:

The net interest margin, excluding incremental accretion on purchased loans, decreased to 3.86% for the quarter ended December 31, 2014 from 4.20% for the same period in 2013 and increased slightly from 3.83% from the linked-quarter ended September 30, 2014.  For the year ended December 31, 2014, the net interest margin, excluding incremental accretion on purchased loans, decreased to 3.97% from 4.32% for the prior year.  The increase from the linked-quarter is due to the change in the earnings asset mix (higher ratio of loans and investments to earning assets and a lower ratio of interest earning deposits to earning assets) partially offset by lower contractual loan note rates. Yields on loans, excluding incremental accretion on purchased loans, decreased to 5.03% for the quarter ended December 31, 2014 from 5.07% for the linked-quarter ended September 30, 2014.

The provision for loan losses for noncovered loans was $1.3 million for the quarter ended December 31, 2014 compared to $200,000 for the quarter ended December 31, 2013 and $567,000 for the linked-quarter ended September 30, 2014.  For the year ended December 31, 2014, the provision for loan losses for noncovered loans was $2.2 million compared to $1.8 million for the prior year.

The provision for loan losses for covered loans totaled $1.5 million for the quarter ended December 31, 2014 compared to $228,000 for the same period in the prior year and $27,000 for the linked-quarter ended September 30, 2014.  For the year ended December 31, 2014, the provision for loan losses for covered loans was $2.4 million compared to $1.9 million for the prior year.

As of the dates of the completion of each of the mergers and acquisitions, acquired loans were recorded at their estimated fair value, including our estimate of future expected cash flows until the ultimate resolution of these credits.  As reflected in the table below, incremental accretion income from acquired loans was $6.8 million for the quarter ended December 31, 2014 compared to $1.5 million for the quarter ended December 31, 2013 and $3.8 million for the linked-quarter ended September 30, 2014.  The increase for the quarter ended December 31, 2014 was due to the increase in incremental accretion income from the Washington Banking Merger.  For the year ended December 31, 2014, incremental accretion income was $14.3 million compared to $6.7 million for the prior year.

For the quarter ended December 31, 2014, the Company recognized $(2.0) million of change in the FDIC indemnification asset compared to $(647,000) and $155,000 for the quarters ended September 30, 2014 and December 31, 2013, respectively.

The following table illustrates the earnings impact associated with the Company's acquired loan portfolios:

Donald J. Hinson, Executive Vice President and Chief Financial Officer, commented, "The incremental accretion income increased from the prior quarter due to a significant amount of payoffs and workouts, as well as some quarter-end adjustments to prior accretion estimates, relating to loans obtained in the Washington Banking Merger.  Many of these loans had discounts that were fully recognized at the time of the payoff or workout. We are estimating that discount accretion over the next couple of quarters will be in the range of $2 million to $3 million depending on loan prepayments. The net interest margin before incremental accretion income continues to experience downward pressure due to the low rate environment.  The Company will continue to focus on balance sheet growth and leverage in order to mitigate the effects of the current rate environment."

Noninterest income was $3.9 million for the quarter ended December 31, 2014 compared to $2.4 million for the same period in 2013 and $5.5 million for the linked-quarter ended September 30, 2014.  For the year ended December 31, 2014, noninterest income was $16.5 million compared to $9.7 million for the year ended December 31, 2013.  The increase compared to the same periods in the prior year was primarily due to the Washington Banking Merger.  The decrease from the linked-quarter was primarily the result of the negative impact from the change in the indemnification asset.  The FDIC indemnification asset decreased $4.0 million to $1.1 million at December 31, 2014 from $5.1 million at September 30, 2014.  Of this decrease, $2.1 million was related to claims made for losses under the shared-loss agreements and $1.6 million was related to valuation adjustments made to the asset.  The shared-loss agreements on non-single family loans covering $107.4 million of covered loans at December 31, 2014 will expire in 2015.  Therefore, a valuation adjustment was recognized for previously estimated losses for which claims are not expected to be made prior to the expiration of the shared-loss agreements.

Mr. Hinson added, "Subsequent to year-end, the Company sold the legacy Heritage Bank merchant card portfolio which will impact future non-interest income.  The total consideration of the sale was $2.2 million.  Of this amount, $1.65 million was received by the Company at time of sale and $550,000 is held in escrow and is contingent on the performance of the portfolio in 2015.  If certain performance thresholds are met, the payment will range between $440,000 and $550,000.  If the thresholds are not met, no contingent payment will be made.  The contingent payment is to be paid on or before December 31, 2015.  With the exception of recognizing the gain on sale of the portfolio, the effects of this sale will lower future merchant visa income to approximately half of the income prior to the sale."

In addition to the Washington Banking Merger, prior year initiatives had a significant impact on noninterest expense during 2013, and increased 2014 expense levels. The following tables illustrate the expenses related to implementing these initiatives.  The amounts reported represent identifiable costs paid to third-party providers as well as any retention bonuses or severance payments made in conjunction with these initiatives.  The amounts do not include costs of additional staffing levels required to complete the initiatives nor do they include future expected cost savings from the Washington Banking Merger. The first table reports these expenses by initiative and the second table reports these expenses by expense category.

The types of expenses associated with the significant expense categories in the table above are summarized as follows:

• Compensation and employee benefits expense consisted substantially of retention bonus and severance packages paid to transitional employees.
• Occupancy and equipment expense consisted primarily of lease termination costs.
• Data processing expense consisted of costs relating to the Company's core system conversion as well as data conversions of NCB, Valley Bank and Whidbey Island Bank to the Company's core system.
• Professional services expense includes fees paid to financial advisors, attorneys, and accountants, and consultant fees related to mergers and acquisitions and to the core system conversion.

Noninterest expense was $29.2 million for the quarter ended December 31, 2014 compared to $18.5 million for the quarter ended December 31, 2013 and $28.4 million for the linked-quarter ended September 30, 2014.  Noninterest expense was $99.4 million for the year ended December 31, 2014 compared to $59.5 million for the year ended December 31, 2013.  The increases are primarily due to the Washington Banking Merger and additional ongoing operating costs from mergers and acquisitions as well as specific costs identified in the table above.

Income tax expense was $1.3 million for the quarter ended December 31, 2014 compared to $432,000 for the comparable quarter in 2013 and $2.8 million for the linked-quarter ended September 30, 2014.  The increase in income tax expense for the quarter ended December 31, 2014 from the prior year end was due to the increase in pre-tax income and was partially offset by tax credits and a $728,000 income tax benefit related to the resolution of a tax position previously taken by Washington Banking Company.  The decrease in income tax expense from the linked-quarter was due to additional tax credits recognized during the quarter and the $728,000 income tax benefit previously mentioned.

Dividend

On January 28, 2015, the Company's Board of Directors declared a quarterly cash dividend of $0.10 per common share payable on February 24, 2015 to shareholders of record on February 10, 2015. 

Earnings Conference Call

The Company will hold a telephone conference call to discuss this earnings release on January 29, 2015 at 11:00 a.m. Pacific time.  To access the call, please dial (800) 230-1059 a few minutes prior to 11:00 a.m. Pacific time.  The call will be available for replay through February 12, 2015, by dialing (800) 475-6701 -- access code 349969.

About Heritage Financial

Heritage Financial Corporation is an Olympia-based bank holding company with Heritage Bank, a full-service commercial bank, as its sole wholly-owned banking subsidiary. Heritage Bank has a branching network of 66 banking offices in Washington and Oregon. Heritage Bank also does business under the Central Valley Bank name in the Yakima and Kittitas counties of Washington and under the Whidbey Island Bank name on Whidbey Island. Heritage's stock is traded on the NASDAQ Global Select Market under the symbol "HFWA".  More information about Heritage Financial Corporation can be found on its website at www.hf-wa.com and more information about Heritage Bank can be found on its website at www.heritagebanknw.com.

Non-GAAP Financial Measures

This news release contains certain non-GAAP (Generally Accepted Accounting Principles) financial measures in addition to results presented in accordance with GAAP.  These measures include tangible common stockholders' equity, tangible book value per share and tangible common stockholders' equity to tangible assets.  Tangible common stockholders' equity (tangible book value) excludes goodwill and other intangible assets.  Tangible assets exclude goodwill and other intangible assets.  Management has presented these non-GAAP financial measures in this earnings release because it believes that they provide useful and comparative information to assess trends in the Company's capital reflected in the current quarter and year-to-date results and facilitate our performance with the performance of our peers.  Where applicable, the Company has also presented comparable earnings information using GAAP financial measures. Reconciliations of the GAAP and non-GAAP financial measures are presented below.

Forward-Looking Statements

This release contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.  Forward-looking statements often include the words "believes," "expects," "anticipates," "estimates," "forecasts," "intends," "plans," "targets," "potentially," "probably," "projects," "outlook" or similar expressions or future or conditional verbs such as "may," "will," "should," "would" and "could." These forward-looking statements are subject to known and unknown risks, uncertainties and other factors that could cause actual results to differ materially from the results anticipated,  including: the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be impacted by deterioration in the housing and commercial real estate markets,  which may lead to increased losses and non-performing assets in our loan portfolio, and may result in our allowance for loan losses not being adequate to cover actual losses, and require us to increase our allowance for loan losses; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; risks related to acquiring assets in or entering markets in which we have not previously operated and may not be familiar; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the Board of Governors of the Federal Reserve System and of our bank subsidiary by the Federal Deposit Insurance Corporation, the Washington State Department of Financial Institutions, Division of Banks or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our allowance for loan losses, write-down assets, change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, which could adversely affect our liquidity and earnings; legislative or regulatory changes that adversely affect our business including changes in regulatory policies and principles, or the interpretation of regulatory capital or other rules as a result of Basel III; the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the implementing regulations; further increases in premiums for deposit insurance; our ability to control operating costs and expenses; the use of estimates in determining the fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our consolidated statements of financial condition; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; failure or security breach of computer systems on which we depend; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our expansion strategy of pursuing acquisitions and denovo branching; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired including those from the Cowlitz Bank, Pierce Commercial Bank,  Northwest Commercial Bank. Valley Community Bancshares and Washington Banking Company transactions, or may in the future acquire into our operations, and our ability to realize related revenue synergies and cost savings within expected time frames, or at all, and any goodwill charges related thereto and costs or difficulties relating to integration matters, including but not limited to customer and employee retention, which might be greater than expected; changes in consumer spending, borrowing and savings habits; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services; and other risks detailed from time to time in our filings with the Securities and Exchange Commission including our Quarterly Reports on Form 10-Q and our Annual Reports on Form 10-K.

The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Company. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for future periods to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company's operating and stock price performance.