HFWA Heritage Financial Corporation

OLYMPIA, Wash., Oct. 25, 2018 /PRNewswire/ -- Heritage Financial Corporation (NASDAQ GS: HFWA) (the "Company" or "Heritage"), the parent company of Heritage Bank, today reported that the Company had net income of $15.5 million for the quarter ended September 30, 2018 compared to $10.6 million for the quarter ended September 30, 2017 and $11.9 million for the linked-quarter ended June 30, 2018. Diluted earnings per common share for the quarter ended September 30, 2018 was $0.42 compared to $0.35 for both the quarter ended September 30, 2017 and the linked-quarter ended June 30, 2018. The impact of acquisition-related expenses was $0.07 per share for the quarter ended September 30, 2018 compared to $0.01 and $0.02 for the quarters ended September 30, 2017 and June 30, 2018, respectively.

The Company had net income of $36.4 million for the nine months ended September 30, 2018, or $1.04 per diluted common share, compared to $31.8 million, or $1.06 per diluted common share, for the nine months ended September 30, 2017. The impact of acquisition-related expenses was $0.21 per share for the nine months ended September 30, 2018 compared to $0.01 for the nine months ended September 30, 2017.

Brian L. Vance, CEO of Heritage, commented, "We are pleased with our overall financial performance for the third quarter of 2018. Excluding the impacts of acquisition-related expenses, we showed very positive earnings improvement.  In addition, due to the combination of our merger with Premier Commercial Bancorp and strong deposit growth in the third quarter, our total assets grew to over $5.28 billion as of September 30, 2018.

We are also pleased to announce that we are increasing our regular quarterly cash dividend to $0.17 per common share and declaring a special dividend of $0.10 payable to our shareholders in November."

Jeffrey J. Deuel, President and Chief Executive Officer of Heritage Bank commented, "It is good to see the positive impact from both the Puget Sound Bancorp, Inc. and Premier Community Bancorp acquisitions which we expect will continue to enhance our performance in future quarters. The additional scale and our continued focus on expense management in the midst of these two transactions is also contributing to our positive performance. Additionally, our ongoing discipline around loan concentration management also positions us well for the future."

Acquisition of Premier Commercial Bancorp

On July 2, 2018, the Company completed the acquisition of Premier Commercial Bancorp ("Premier Commercial"), the holding company for Premier Community Bank, both of Hillsboro, Oregon ("Premier Merger").  As of the acquisition date, Premier Commercial was merged with and into Heritage and Premier Community Bank was merged with and into Heritage Bank.

Pursuant to the terms of the merger agreement, Premier Commercial shareholders received 0.4863 shares of Heritage common stock in exchange for each share of Premier Commercial common stock based on the Heritage closing date per share price on June 29, 2018 of $34.85. Heritage issued an aggregate of 2,848,579 shares of its common stock and paid cash of $2,000 for fractional shares in the transaction for total consideration paid of $99.3 million.

Acquisition of Puget Sound Bancorp, Inc.

On January 16, 2018, the Company completed the acquisition of Puget Sound Bancorp, Inc. ("Puget Sound"), the holding company for Puget Sound Bank, both of Bellevue, Washington ("Puget Sound Merger"). As of the acquisition date, Puget Sound merged into Heritage and Puget Sound Bank merged into Heritage Bank.

Pursuant to the terms of the merger agreement, Puget Sound shareholders received 1.1688 shares of Heritage common stock in exchange for each share of Puget Sound stock. Heritage issued an aggregate of 4,112,258 shares of its common stock at the closing date per share price on January 12, 2018 of $31.80 and paid cash of $3,000 for fractional shares in the transaction for total consideration paid of $130.8 million.

Acquisition Accounting

The Premier Merger and Puget Sound Merger (collectively the "Premier and Puget Mergers") were accounted for using the acquisition method of accounting. Accordingly, Heritage's cost to acquire Premier Commercial and Puget Sound were allocated to the assets (including identifiable intangible assets) and the liabilities at their respective estimated fair values as of the acquisition dates. The excess of the purchase price over the fair value of the net assets acquired was allocated to goodwill. Fair values on the acquisition date are preliminary and represent management's best estimates based on available information and facts and circumstances in existence on the acquisition date. Fair values are subject to refinement for up to one year after the closing date of the acquisition as additional information regarding the closing date fair values becomes available.

The following table provides the estimated fair value of the assets acquired and liabilities assumed at the merger dates for each merger (in thousands):

Balance Sheet

The Company's total assets increased $486.7 million, or 10.2%, to $5.28 billion at September 30, 2018 from $4.79 billion at June 30, 2018 primarily as a result of the Premier Merger.  Assets acquired, including goodwill, from the Premier Merger totaled $440.4 million at the closing date of July 2, 2018.

Investment securities increased $47.1 million, or 5.4%, to $920.7 million at September 30, 2018 from $873.7 million at June 30, 2018 primarily as a result of investment purchases of $120.5 million, of which $4.5 million were acquired in the Premier Merger. The increase in investment securities was partially offset by sales of $44.9 million, maturities, calls and payments of investment securities of $23.2 million and an increase in unrealized losses of $4.3 million due to rising interest rates that negatively impacted the fair value of our bond portfolio.

Total loans receivable, net of allowance for loan losses, increased $320.3 million, or 9.7%, to $3.61 billion at September 30, 2018 from $3.29 billion at June 30, 2018.  Total loans receivable, net, excluding the $330.1 million of loans acquired in the Premier Merger, decreased $9.8 million during the three months ended September 30, 2018 due to a significant amount of prepayments during the quarter.

Total deposits increased $429.2 million, or 10.8%, to $4.40 billion at September 30, 2018 from $3.97 billion at June 30, 2018 primarily as a result of the deposits acquired in the Premier Merger totaling $318.7 million. Total deposits, excluding those acquired in the Premier Merger, increased $110.5 million, or 2.8%.The acquired deposits had the following composition at the merger date of July 2, 2018 (in thousands):

The increase in deposits, excluding the deposits acquired in the Premier Merger, included increases in noninterest bearing demand deposit accounts of $52.9 million, or 4.6%, and money market accounts of $44.0 million, or 7.4%, offset partially by decreases in certificates of deposit accounts of $12.4 million, or 2.7%. Non-maturity deposits as a percentage of total deposits increased slightly to 88.5% as of September 30, 2018 from 88.4% as of June 30, 2018.

The Company had no Federal Home Loan Bank advances at September 30, 2018 compared to $75.5 million at June 30, 2018. The Company was able to pay down the advances, including the $16.0 million acquired in the Premier Merger, due to the increase in deposits during the quarter.

Total stockholders' equity increased $106.6 million, or 16.7%, to $746.1 million at September 30, 2018 from $639.5 million at June 30, 2018. Changes in stockholders' equity during the three and nine months ended September 30, 2018 were as follows (in thousands):

The Company and Heritage Bank continue to maintain capital levels in excess of the applicable regulatory requirements for them to be categorized as "well-capitalized". The Company had common equity Tier 1 risk-based, Tier 1 leverage, Tier 1 risk-based and total risk-based capital ratios of 11.4%, 10.4%, 11.8% and 12.6%, respectively, at September 30, 2018, compared to 11.2%, 10.4%, 11.7% and 12.6%, respectively, at June 30, 2018 and 11.4%, 10.4%, 12.0% and 13.0%, respectively, at September 30, 2017.

Credit Quality

The allowance for loan losses increased $503,000, or 1.5%, to $34.5 million at September 30, 2018 from $34.0 million at June 30, 2018. The increase was due to provision for loan losses of $1.1 million recorded during the quarter ended September 30, 2018, offset partially by net charge-offs of $562,000 recognized during the same period.

Nonperforming loans to loans receivable, net, decreased to 0.41% at September 30, 2018 from 0.50% at June 30, 2018 due primarily to a decrease in nonaccrual loans of $1.7 million, or 10.5%, to $14.8 million at September 30, 2018 from $16.5 million at June 30, 2018. The decrease was due substantially to one agricultural loan relationship in the amount of $2.7 million that paid in full during the quarter ended September 30, 2018, offset partially by one new commercial lending relationship totaling $1.0 million.

Changes in nonaccrual loans during the quarter ended September 30, 2018 were as follows (in thousands):

The allowance for loan losses to nonperforming loans was 233.25% at September 30, 2018 compared to 205.60% at the linked-quarter ended June 30, 2018. Nonperforming assets decreased to 0.32% of total assets at September 30, 2018 compared to 0.35% of total assets at June 30, 2018 based on the decrease in nonaccrual loans discussed above, partially offset by the $1.8 million increase in other real estate owned during the quarter ended September 30, 2018 primarily as a result of the Premier Merger.

Potential problem loans increased $4.3 million, or 4.2%, to $105.7 million at September 30, 2018 compared to $101.5 million at June 30, 2018 due primarily to potential problems loans acquired in the Premier Merger.  Changes in potential problem loans during the quarter ended September 30, 2018 were as follows (in thousands):

The allowance for loan losses to loans receivable, net, decreased to 0.94% at September 30, 2018 from 1.02% at June 30, 2018 primarily as a result of the Premier Merger. Included in the carrying value of loans are net discounts on loans purchased in mergers and acquisitions which may reduce the need for an allowance for loan losses on these loans because they are carried at an amount below the outstanding principal balance.  The carrying value of the loans acquired in the Premier Merger was $330.1 million and the related fair value discount was $5.3 million, or 1.60% of the acquired balance. 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 September 30, 2018. The remaining net discount on purchased loans, including the related fair value discount acquired in the Premier Merger, was $13.4 million at September 30, 2018 compared to $10.6 million at June 30, 2018.

Net charge-offs were $562,000 for the quarter ended September 30, 2018 compared to net charge-offs of $2.2 million for the same quarter in 2017 and net charge-offs of $1.0 million for the linked-quarter ended June 30, 2018. The decrease in net charge-offs compared to the linked-quarter was due primarily to lower commercial and industrial loan charge-offs. The majority of the charge-offs recorded during the quarter ended September 30, 2018 relate to smaller charge-off balances on a large volume of consumer loans.

Operating Results

Net interest income increased $16.2 million, or 46.2%, to $51.1 million for the quarter ended September 30, 2018 compared to $34.9 million for the same period in 2017 and increased $7.4 million, or 16.8%, from $43.7 million for the linked-quarter ended June 30, 2018. Net interest income increased $33.5 million, or 32.7%, to $135.7 million for the nine months ended September 30, 2018 compared to $102.2 million for the nine months ended September 30, 2017. The increases in net interest income for all periods noted were primarily due to increases in average interest earning assets, which increased substantially as a result of the Premier and Puget Mergers. In addition, the yield on total interest earning assets increased 59 basis points to 4.71% for the quarter ended September 30, 2018 compared to 4.12% for the comparable period in 2017 and increased 21 basis points from 4.50% for the linked quarter ended June 30, 2018. Yield on total interest earning assets increased 42 basis points to 4.54% for the nine months ended September 30, 2018 compared to 4.12% for the nine months ended September 30, 2017. Yields on total interest earning assets increased primarily due to higher market interest rates reflecting increases in the target federal funds rate. The increases in net interest income for all periods were offset partially by increases in the cost of total interest bearing liabilities primarily as a result of rising interest rates. The cost of total interest bearing liabilities increased eight basis points to 0.44% during the quarter ended September 30, 2018 compared to 0.36% for the quarter ended September 30, 2017 and increased three basis points from 0.41% for the linked-quarter ended June 30, 2018. The cost of total interest bearing liabilities increased eight basis points to 0.40% for the nine months ended September 30, 2018 compared to 0.32% for the same period in 2017.

Net interest margin increased 55 basis points to 4.41% for the quarter ended September 30, 2018 from 3.86% for the same period in 2017 and increased 19 basis points from 4.22% for the linked-quarter ended June 30, 2018.  The net interest margin increased 37 basis points for the nine months ended September 30, 2018 to 4.26% from 3.89% for the same period in 2017.  Increases in net interest margin were due primarily to the increases in net interest income as discussed above with the primary contributor being the increases in both the average loan balance and loan yield.

The loan yield, excluding incremental accretion on purchased loans, increased 44 basis points to 5.01% for the quarter ended September 30, 2018 compared to 4.57% for the quarter ended September 30, 2017 and increased 20 basis points from 4.81% for the linked-quarter ended June 30, 2018. Loan yield, excluding incremental accretion on purchased loans, increased 30 basis points to 4.85% for the nine months ended September 30, 2018 compared to 4.55% for same period in 2017. The increases in loan yields, excluding incremental accretion of purchased loans, from prior periods was due to a combination of higher contractual loan rates as a result of the increasing interest rate environment as well as an increase in loan yields from the loans acquired in the Premier and Puget Mergers as compared to legacy Heritage loans.

The impact on loan yield from incremental accretion on purchased loans increased 14 basis points to 0.29% for the quarter ended September 30, 2018 compared to 0.15% for the quarter ended September 30, 2017 and increased five basis points from 0.24% for the linked-quarter ended June 30, 2018. The impact on loan yield from incremental accretion on purchased loans increased seven basis points to 0.25% for the nine months ended September 30, 2018 from 0.18% for the same period in 2017. The increases from all prior periods was primarily a result of the loans acquired in the Premier and Puget Mergers. The incremental accretion and the impact to loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the purchased loans decreases.

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

In addition to loan yields, also impacting net interest margin were increases in the yields on investment securities. The yields on the aggregate investment portfolio increased 34 basis points to 2.58% for the quarter ended September 30, 2018 compared to 2.24% for the quarter ended September 30, 2017 and increased five basis points from 2.53% for the linked-quarter ended June 30, 2018. The yields on the aggregate investment portfolio increased 27 basis points to 2.51% for the nine months ended September 30, 2018 compared to 2.24% for the nine months ended September 30, 2017. The increases compared to the prior periods primarily reflect the effect of the rise in interest rates on our adjustable rate investment securities as well as higher rates on new purchases of investments.

The total cost of deposits increased seven basis points to 0.27% during the quarter ended September 30, 2018 compared to 0.20% during the same quarter in 2017 and increased four basis points from 0.23% during the linked-quarter ended June 30, 2018. The total cost of deposits increased six basis points to 0.24% during the nine months ended September 30, 2018 compared to 0.18% during the same period in 2017.

The interest expense from FHLB advances and other borrowings decreased to $117,000 for the quarter ended September 30, 2018 as the Company paid off all the FHLB advances during the quarter. The average balance of FHLB advances decreased to $20.9 million during the quarter ended September 30, 2018 compared to $111.3 million during the same period in 2017 and decreased from an average balance of $79.1 million during the linked-quarter ended June 30, 2018. The cost of FHLB advances increased 69 basis points to 2.22% during the quarter ended September 30, 2018 compared to 1.53% during the same quarter in 2017 and increased 18 basis points from 2.04% during the linked-quarter ended June 30, 2018.

Donald J. Hinson, Executive Vice President and Chief Financial Officer, commented, "We are pleased with the continued improvement in our net interest margin. This has been accomplished primarily through increases in pre-accretion loan yield while experiencing only marginal increases in costs of total deposits. The weighted average note rate on new loans originated during quarter ended September 30, 2018 increased to 5.49% from 5.18% for the quarter ended June 30, 2018 and from 4.45% for the quarter ended September 30, 2017. These increases in rates on new loans, as well as the repricing of adjustable rate loans, has resulted in significant increases in pre-accretion loan yield."

The provision for loan losses increased $181,000, or 20.5%, to $1.1 million for the quarter ended September 30, 2018 compared to $884,000 for the quarter ended September 30, 2017 and decreased $685,000, or 39.1%, from the linked-quarter ended June 30, 2018. The provision for loan losses increased $1.1 million, or 37.6%, to $4.0 million for the nine months ended September 30, 2018 compared to $2.9 million for the nine months ended September 30, 2017. The amount of provision for loan losses was necessary to increase the allowance for loan losses to an amount that management determined to be appropriate at September 30, 2018 based on the use of a consistent methodology. The increase in the provision for loan losses compared to the 2017 periods was primarily as a result of increases in total loan balances as a result of mergers. The decrease in the provision for loan losses compared to the linked-quarter end was due primarily to a lower organic loan growth rate.

Noninterest income decreased $363,000, or 4.3%, to $8.1 million for the three months ended September 30, 2018 compared to $8.4 million for the three months ended September 30, 2017 and decreased $3.3 million, or 12.5%, to $23.2 million for the nine months ended September 30, 2018 compared to $26.5 million for the same period in 2017. These decreases from the prior periods were due primarily to a decrease in gain on sale of loans, including a $3.0 million gain on the sale of a previously classified purchased credit impaired loan during the quarter ended June 30, 2017. The decrease in noninterest income was offset partially by increases in service charges and other fees due primarily to changes in fee structures on business deposit accounts completed during the quarter ended June 30, 2017 in addition to increases in deposit balances. Noninterest income increased $507,000, or 6.7%, compared to linked-quarter ended June 30, 2018 primarily due to a gain on sale of a branch held for sale recognized in other income of $382,000 during the three months ended September 30, 2018.

Noninterest expense increased $11.6 million, or 41.6%, to $39.6 million for the quarter ended September 30, 2018 compared to $28.0 million for the same period in 2017. Noninterest expense increased $29.1 million, or 35.0%, to $112.1 million for the nine months ended September 30, 2018 compared to $83.0 million for the same period in 2017. The increases were primarily due to expenses from the Premier and Puget Mergers, including increases related to compensation and employee benefits due to additional employees, occupancy and equipment expense primarily due to additional rent expense, and additional data processing expense due to an increase in transactional accounts and balances. Noninterest expense also increased during the three and nine months ended September 30, 2018 compared to both periods in 2017 due to increases in the amortization of intangible assets of $836,000 and $1.9 million recorded during the quarter and nine months ended September 30, 2018, respectively, relating to the Premier and Puget Mergers.   Noninterest expenses increased compared to the linked-quarter ended June 30, 2018 due substantially to the Premier Merger.

Professional services increased during the three and nine months ended September 30, 2018 compared to the same periods in 2017 primarily due to acquisition-related expenses. Professional services decreased compared to the linked-quarter ended June 30, 2018, due substantially to the buy-out of a third party contract in the amount $1.7 million during the quarter ended June 30, 2018. The third party assisted the Company in its deposit product realignment and was compensated based on success factors over three years subsequent to implementation. The Company assessed the contract and determined that it was advantageous to buy-out the contract prior to the system conversions relating to the Premier and Puget Mergers. The Company expects the accumulated savings in future professional services expenses to fully offset the cost of the buy-out by the end of 2019.

Noninterest expense increased $3.9 million, or 10.9%, from $35.7 million for the linked-quarter ended June 30, 2018 primarily due to non-recurring compensation and employee benefits expense related to the Premier Merger paid during the third quarter 2018, offset partially by the non-recurring contract buy-out in second quarter 2018 described above.

Acquisition-related expenses incurred as a result of the Premier and Puget Sound Mergers were approximately $3.4 million during the quarter ended September 30, 2018 compared to $880,000 during the linked-quarter ended June 30, 2018. For the nine months ended September 30, 2018, acquisition-related expenses totaled $9.1 million. For the three and nine months ended September 30, 2017, acquisition-related expenses totaled $387,000. Acquisition costs are primarily included in compensation and employee benefits, professional services and data processing expenses.

The ratio of noninterest expense to average assets (annualized) was 2.98% for the quarter ended September 30, 2018 compared to 2.76% for the same period in 2017 and was 3.09% for nine months ended September 30, 2018 compared to 2.82% for the same period in 2017. The increase from the prior periods was due primarily to acquisition-related expenses and the increase in the amortization of intangible assets. The ratio of noninterest expense to average assets (annualized) decreased from 3.03% for the linked-quarter ended June 30, 2018 primarily based on the proportional increase in average assets to the increase in noninterest expense discussed above.

Income tax expense was $3.0 million for the quarter ended September 30, 2018 compared to $3.9 million for the quarter ended September 30, 2017 and $2.0 million for the linked-quarter ended June 30, 2018. The effective tax rate was 16.3% for the quarter ended September 30, 2018 compared to 27.0% for the comparable quarter in 2017 and 14.5% for the linked-quarter ended June 30, 2018. Income tax expense was $6.4 million for the nine months ended September 30, 2018 compared to $11.1 million for the nine months ended September 30, 2017. The effective tax rate was 15.0% for the nine months ended September 30, 2018 compared to 25.9% for the nine months ended September 30, 2017. The decrease in the income tax expense and the effective tax rate compared to the same periods in 2017 was due primarily to the impact of the Tax Cuts and Jobs Act enacted in December 2017 which lowered the corporate income tax rate from 35% to 21%.  The increase in income tax expense compared to the linked-quarter was primarily due to an increase in pre-tax income without a corresponding increase in tax-exempt income.

Dividends

On October 24, 2018, the Company's Board of Directors declared a quarterly cash dividend of $0.17 per common share and a special cash dividend in the amount of $0.10 per common share. The dividends are payable on November 21, 2018 to shareholders of record as of the close of business on November 7, 2018.

Earnings Conference Call

The Company will hold a telephone conference call to discuss this earnings release on October 25, 2018 at 11:00 a.m. Pacific time. To access the call, please dial (877) 209-9921 a few minutes prior to 11:00 a.m. Pacific time. The call will be available for replay through November 9, 2018, by dialing (800) 475-6701 -- access code 455201.

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 64 banking offices in Washington and Oregon. Heritage Bank does business 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 comparison of 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 press release includes "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements often include words such as "believe," "expect," "anticipate," "estimate," and "intend" or future or conditional verbs such as "will," "would," "should," "could," or "may." Forward-looking statements are not historical facts but instead represent management's current expectations and forecasts regarding future events, many of which are inherently uncertain and outside of our control. Actual results may differ, possibly materially, from those currently expected or projected in these forward-looking statements. Factors that could cause our actual results to differ materially from those described in the forward-looking statements, include the expected revenues, cost savings, synergies and other benefits from the Premier and Puget Mergers might not be realized within the expected time frames or at all, and costs or difficulties relating to integration matters, including but not limited to, customer and employee retention might be greater than expected; increased competitive pressures; changes in the interest rate environment; changes in general economic conditions and conditions within the securities markets; legislative and regulatory changes; and other factors described in Heritage's latest annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other documents filed with or furnished to the Securities and Exchange Commission-which are available on our website at www.heritagebanknw.com and on the SEC's website at www.sec.gov. The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, any of the forward-looking statements that we make in this press release or the documents we file with or furnish to the SEC are based only on information then actually known to the Company and upon management's beliefs and assumptions at the time they are made which may turn out to be wrong because of inaccurate assumptions we might make, because of the factors described above or because of other factors that we cannot foresee. 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 2018 and beyond 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.