SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 1997
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number __________
HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Washington 91-1857900
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
201 Fifth Avenue SW, Olympia, WA 98501
(Address of principal executive office) (ZIP Code)
(360) 943-1500
(Registrant's telephone number, including area code)
Not Applicable
(Former name, former address and former
fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
As of January 30, 1998 there were outstanding 9,751,464 common shares, with no
par value, of the registrant.
Page 1
HERITAGE FINANCIAL CORPORATION
FORM 10-Q
INDEX
PART I. Financial Information Page
- ----------------------------------------------------------------------------------
Item 1. Condensed Financial Statements (Unaudited)
Consolidated Statements of Income for the Three and
Six Months Ended December 31, 1997 and 1996 3
Consolidated Statements of Financial Condition
As of December 31, 1997 and June 30, 1997 4
Consolidated Statement of Stockholders' Equity
for the Six months Ended December 31, 1997 5
Consolidated Statements of Cash Flows for the
Six months Ended December 31, 1997 and 1996 6
Notes to Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 10
PART II. Other Information
Item 6. Exhibits and Reports on Form 8-K 20
Signatures 20
Page 2
HERITAGE SAVINGS BANK AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in Thousands Except for Per Share Data)
(Unaudited)
Three Months Ended Six Months Ended
December 31, December 31,
--------------------------------------
1996 1997 1996 1997
------ ----- ----- ------
INTEREST INCOME:
Loans $4,060 4,857 7,955 9,599
Mortgage backed securities 117 102 240 208
Investment securities and FHLB dividends 206 142 445 296
Interest bearing deposits 208 279 410 327
--------------------------------------
Total interest income 4,591 5,380 9,050 10,430
INTEREST EXPENSE:
Deposits 2,270 2,571 4,516 4,968
Borrowed funds -- -- -- 8
--------------------------------------
Total interest expense 2,270 2,571 4,516 4,976
--------------------------------------
Net interest income 2,321 2,809 4,534 5,454
PROVISION FOR LOAN LOSSES -- 30 -- 60
--------------------------------------
Net interest income after provision 2,321 2,779 4,534 5,394
NONINTEREST INCOME:
Gains on sales of loans 537 560 1,113 1,102
Commissions on sales of annuities
and securities 44 23 90 75
Service charges on deposits 121 133 230 254
Rental income 52 52 109 104
Gains on sale of premises -- -- -- 36
Other income 92 112 170 202
--------------------------------------
Total noninterest income 846 880 1,712 1,773
NONINTEREST EXPENSE:
Salaries and employee benefits 1,361 1,494 2,672 2,963
Building occupancy 400 434 774 857
FDIC premiums and special assessment 30 33 1,229 65
Data processing 138 177 258 324
Marketing 54 97 98 181
Office supplies and printing 64 68 125 128
Other 342 354 647 702
--------------------------------------
Total noninterest expense 2,389 2,657 5,803 5,220
--------------------------------------
Income before federal income tax (benefit) 778 1,002 443 1,947
Federal income tax (benefit) 266 356 (785) 691
--------------------------------------
Net income $ 512 646 1,228 1,256
Earnings per share:
Basic $ 0.28 0.36 0.68 0.69
Diluted $ 0.28 0.35 0.67 0.69
See Notes to Consolidated Financial Statements
Page 3
HERITAGE SAVINGS BANK AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in Thousands)
(Unaudited)
JUNE 30, DECEMBER 31,
1997 1997
-----------------------------
ASSETS
Cash on hand and in banks $ 7,412 6,842
Interest earning deposits 175 80,911
Investment securities held to maturity 8,506 7,698
Mortgage backed securities held to maturity 5,159 4,709
Loans held for sale 6,323 5,042
Loans receivable 201,870 210,449
Less: Allowance for loan losses (2,752) (2,812)
-----------------------------
Loans, net 199,118 207,637
Premises and equipment, net 12,202 11,864
Federal Home Loan Bank stock 1,511 1,572
Accrued interest receivable 1,380 1,584
Prepaid expenses and other assets 378 742
-----------------------------
$242,164 328,601
=============================
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits 209,781 223,887
Stock subscription funds held for closing -- 72,506
Advances from Federal Home Loan Bank 890 --
Advance payments by borrowers for taxes and insurance 473 475
Accrued expenses and other liabilities 2,605 2,062
Deferred Federal income taxes 701 701
-----------------------------
214,450 299,631
Stockholders' equity:
Preferred stock, $1 par value per share. 5,000,000 shares authorized:
none outstanding -- --
Common stock, $1 par value per share 10,000,000 shares authorized:
1,809,616 shares outstanding 1,810 1,810
Additional paid-in capital 4,103 4,103
Retained earnings, substantially restricted 21,801 23,057
-----------------------------
Total stockholders' equity 27,714 28,970
Commitments and contingencies
-----------------------------
$242,164 328,601
=============================
See Notes to Consolidated Financial Statements
Page 4
HERITAGE SAVINGS BANK AND SUBSIDIARY
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
Six Months Ended December 31, 1997
(Dollars in Thousands)
(Unaudited)
ADDITIONAL TOTAL
COMMON PAID IN RETAINED STOCKHOLDERS'
STOCK CAPITAL EARNINGS EQUITY
-----------------------------------------------------------
Balance at June 30, 1997 $1,810 4,103 21,801 27,714
Exercise of stock options -- -- -- --
Net income -- -- 1,256 1,256
Cash dividend paid -- -- -- --
-----------------------------------------------------------
Balance at December 31, 1997 $1,810 4,103 23,057 28,970
===========================================================
See Notes to Consolidated Financial Statements
Page 5
HERITAGE SAVINGS BANK AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in Thousands)
(Unaudited)
Six Months Ended
December 31,
----------------------
1996 1997
----------- ----------
Cash flows from operating activities:
Net income $ 1,228 1,256
Adjustments to reconcile net income to net
cash provided by operating activities
Depreciation and amortization 456 501
Deferred loan fees, net of amortization 55 (38)
Provision for loan losses -- 60
Net increase in loans held for sale 1,692 1,281
Deferred Federal income tax expense (benefit) (676) --
Federal Home Loan Bank stock dividends (57) (61)
Net change in accrued interest receivable,
prepaid expenses and other assets, and accrued
expenses and other liabilities 761 (1,111)
----------------------
Net cash provided by operating activities 3,459 1,888
----------------------
Cash flows from investing activities:
Loans originated, net of principal payments and loan sales (13,438) (8,541)
Principal payments of mortgage backed securities 345 457
Proceeds from:
Maturities of investment securities held to maturity 7,585 2,770
Purchase of investment securities held to maturity (1,860) (1,950)
Purchase of premises and equipment (1,390) (182)
----------------------
Net cash used in investing activities (8,758) (7,446)
----------------------
Cash flows from financing activities:
Net increase in deposits 10,558 14,106
Net decrease in FHLB advances -- (890)
Net decrease in advance payment by borrowers
for taxes and insurance 13 2
Cash dividends paid (228) --
Proceeds from exercise of stock options 23 --
Proceeds received and held for stock conversion 72,506
----------------------
Net cash provided by financing activities 10,366 85,724
----------------------
Net increase in cash and cash equivalents 5,067 80,166
Cash and cash equivalents at beginning of period 18,082 7,587
----------------------
Cash and cash equivalents at end of period $ 23,149 87,753
======================
Supplemental disclosures of cash flow information:
Cash payments for:
Interest expense $ 4,506 5,010
Federal income taxes 420 540
See Notes to Consolidated Financial Statements
Page 6
HERITAGE SAVINGS BANK AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Six Months Ended December 31, 1997 and 1996
(Dollars in Thousands)
(Unaudited)
NOTE 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
(a.) Description of Business
Heritage Savings Bank, (the "Bank"), a Washington State stock savings bank, does
business primarily in Thurston, Mason and Pierce counties. The Bank
traditionally has offered a variety of savings products and originated one- to
four-family mortgage loans (principally for sale in the secondary market) and,
to a lesser extent, multi-family, commercial real estate and construction loans.
Beginning in fiscal 1994, the Bank began to implement a growth strategy which is
intended to broaden its products and services from traditional thrift products
and services to those more closely related to commercial banking. That strategy
entails (1) geographic and product expansion, (2) loan portfolio
diversification, (3) development of relationship banking, and (4) maintenance of
asset quality. The Bank intends to continue to fund its assets primarily with
retail deposits, although FHLB advances may be used as a supplemental source of
funds, and it believes that the capital raised in the recent stock offering will
enhance its ability to continue implementing its growth strategy.
(b.) Basis of Presentation
Heritage Financial Corporation (the "Company") was recently organized as the
holding company for the Bank. Effective January 8, 1998, the Company closed its
second step conversion and stock offering which resulted in $66.1 million in
gross proceeds. Effective January 9, 1998, the Company's common stock began to
trade on the Nasdaq National Market under the symbol "HFWA". Prior to January 8,
1998 the Bank was majority-owned by Heritage Financial Corporation, M.H.C.
(MHC), a Washington state mutual holding company, whose securities were not
registered pursuant to the Securities Exchange Act of 1934, nor publicly traded.
Effective January 8, 1998, the MHC was merged into the Bank.
The financial statements shown herein are for the Bank only as the Company did
not engage in material transactions until after January 8, 1998. At December 31,
1997, the Company was inactive and has no significant assets, liabilities,
revenues, expenses or contingent liabilities. The accompanying consolidated
financial statements have been prepared, without audit, pursuant to the rules
and regulations of the Securities and Exchange Commission. Accordingly, they do
not include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements. These consolidated
financial statements should be read in conjunction with the Bank's June 30, 1997
audited consolidated financial statements and notes thereto included in the
Company's recent Registration Statement on Form S-1 filed with the Securities
and Exchange Commission under file number 333-35573. In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included. Operating results for the
six
7
months ended December 31, 1997 are not necessarily indicative of the results
that may be expected for the year ended June 30, 1998. In preparing the
consolidated financial statements, management is required to make estimates and
assumptions that affect the reported amounts of assets and liabilities as of the
dates of the balance sheets, contingent assets and liabilities and revenues and
expenses for the periods presented.
NOTE 2. STOCKHOLDERS' EQUITY
(a.) Stock Offering and Conversion
Effective January 8, 1998, the Company sold 6.6 million shares of its common
stock at a subscription price of $10 per share to the Bank's customers, its
existing stockholders and the general public.
Of the 1.8 million shares of Heritage Savings Bank common stock outstanding at
December 31, 1997, 1.2 million shares owned by Heritage Financial Corporation,
M.H.C. (the "Mutual Holding Company") were canceled on January 8, 1998 and the
Mutual Holding Company was merged into the Bank. The remaining 0.6 million
shares of the Bank's common stock owned by its stockholders were converted into
3.1 million shares of the Company's common stock outstanding.
At December 31, 1997, the Bank held $72.5 million in escrow pending the close of
the stock offering. Approximately $13 million of these funds were returned to
subscribers at the close of the offering due to an oversubscription.
(b.) Earnings per Share
The Company adopted the Financial Accounting Standards Board ("FASB") Statement
No. 128, "Earnings Per Share" for the period ending December 31, 1997. This
statement establishes standards for computing and presenting earnings per share
("EPS"). It replaced the presentation of primary EPS with a presentation of
basic EPS. It also requires dual presentation of basic and diluted EPS on the
face of the income statement for all entities with complex capital structures
and requires a reconciliation of the numerator and denominator of the basic EPS
computation to the numerator and denominator of the diluted EPS computation.
Basic earnings per share is computed by dividing income available to common
stockholders (the numerator) by the weighted average number of common shares
outstanding (the denominator) during the period. Shares issued during the period
and shares reacquired during the period are weighted for the portion of the
period that they were outstanding. The weighted average number of common shares
outstanding for the three month period ended December 31, 1997 and 1996 was
1,809,616 and 1,807,999, respectively. The weighted average number of common
shares outstanding for the six month period ended December 31, 1997 and 1996 was
1,809,616 and 1,807,174, respectively.
Diluted earnings per share is similar to the computation of basic earnings per
share except that the denominator is increased to include the number of
additional common shares that would have been outstanding if the dilutive
options outstanding had been
8
exercised. The weighted average number of common and dilutive potential common
shares outstanding for the three month period ended December 31, 1997 and 1996
was 1,828,499 and 1,824,900, respectively. The weighted average number of common
and dilutive potential common equivalent shares outstanding for the six month
period ended December 31, 1997 and 1996 was 1,827,953 and 1,823,382,
respectively.
Earnings per share information for periods prior to January 8, 1998 is based on
the historical weighted average common shares outstanding for the Bank during
the applicable period. This earnings per share information will not be
comparable to future earnings per share information due to the effects of the
conversion and stock offering closed in January 1998.
(c.) Regulatory Capital
Pursuant to minimum capital requirements of the Federal Deposit Insurance
Corporation, the Bank is required to maintain a leverage ratio (capital to
average assets ratio) of 3% and risk based capital ratios of Tier 1 capital and
total capital (to total risk weighted assets) of 4% and 8%, respectively. At
June 30, 1997, the Bank exceeded the minimum capital requirements as shown below
and the requirements for well capitalized institutions (leverage ratio of 5%,
Tier 1 risk based capital ratio of 6% and total risk based capital ratio of
10%). As of December 31, 1997, the Bank was classified as a "well capitalized"
institution under the criteria established by the FDIC Act.
The following table sets forth the Bank's compliance with its regulatory capital
requirements at December 31, 1997:
AMOUNT PERCENT
---------------------
Tier 1 (leverage) capital:
Actual $28,970 10.9%
Required 7,943 3.0%
---------------------
Excess 21,027 7.9%
Tier 1 risk based capital:
Actual 28,970 14.5%
Required 7,976 4.0%
---------------------
Excess 20,994 10.5%
Total risk based capital:
Actual 31,466 15.8%
Required 15,951 8.0%
---------------------
Excess 15,515 7.8%
On September 30, 1996, legislation was signed into law to recapitalize the
Savings Association Insurance Fund (SAIF). The effect of this legislation was to
require a one-time assessment on all federally insured savings institutions'
deposits under SAIF at .657% of insured deposits at March 31, 1995. The Bank's
assessment was approximately $1.1 million which was charged to earnings in the
quarter ended September 30, 1996 and paid in November 1996.
Page 9
NOTE 3. FEDERAL INCOME TAXES
The Bank recorded a Federal income tax benefit of $785,000 for the six months
period ended December 31, 1996 as a result of the reversal of $938,000 deferred
tax liability related to the potential recapture of the pre-1988 additions to
the tax bad debt reserve which could have been triggered by the Mutual Holding
company reorganization in January 1994. Based on subsequent legislation in
August 1996, the Bank reversed the $938,000 deferred tax liability as a
reduction of Federal income tax expense during the quarter ended September 30,
1996.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
THIS DISCUSSION AND ANALYSIS CONTAINS CERTAIN FORWARD-LOOKING TERMINOLOGY SUCH
AS "BELIEVES", "ANTICIPATES", "WILL", AND "INTENDS", OR COMPARABLE TERMINOLOGY.
SUCH STATEMENTS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES THAT COULD CAUSE
ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE PROJECTED. POTENTIAL PURCHASERS
OF THE COMPANY'S SECURITIES ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON SUCH
FORWARD-LOOKING STATEMENTS WHICH ARE QUALIFIED IN THEIR ENTIRETY BY THE CAUTIONS
AND RISKS DESCRIBED HEREIN AND IN OTHER REPORTS FILED BY THE COMPANY WITH THE
SECURITIES AND EXCHANGE COMMISSION.
FINANCIAL CONDITION DATA
The Bank's total assets at December 31, 1997 were $328.6 million, a 36% increase
from June 30, 1997. Of the $86.4 million increase in total assets from June 30,
1997, $78.9 million were funds related to the recent stock offering which closed
January 8, 1998. Approximately $13 million of these funds were returned to
subscribers at the close of the offering due to an oversubscription. Excluding
the effect of the stock subscription proceeds, total assets were $249.7 million
at December 31, 1997. Net loans outstanding and loans held for sale totaled
$212.7 million at December 31, 1997, an increase of 19% from December 31, 1996
and a 4% increase from June 30, 1997. Excluding the $72.5 million of stock
subscription funds held in escrow for the stock offering at December 31, 1997,
deposits amounted to $223.9 million at December 31, 1997, an increase of 11%
from December 31, 1996 and a 7% increase from June 30, 1997. Of this total, $5.3
million in stock subscription funds were withdrawn from certificates of deposit
at the closing of the stock offering in January 1998.
The Bank's allowance for loan losses at December 31, 1997 was $2.8 million, or
1.3% of outstanding loans. Nonperforming assets (comprised only of nonaccrual
loans) at December 31, 1997 amounted to $344,000, or 0.10% of total assets.
There were no loan charge-offs or recoveries during the six months ended
December 31, 1997.
Page 10
NET INTEREST INCOME
The Bank's profitability depends primarily on its net interest income, which is
the difference between the income it receives on its loan and investment
portfolio and its cost of funds, which consists of interest paid on deposits and
borrowed funds. Changes in net interest income result from changes in volume,
net interest spread and net interest margin. Volume refers to the average dollar
amounts of interest earning assets and interest bearing liabilities. Net
interest spread refers to the difference between the average yield on interest
earning assets and the average cost of interest bearing liabilities. Net
interest margin refers to net interest income divided by average interest
earning assets and is influenced by the level of relative mix of interest
earning assets and interest bearing liabilities.
The following table sets forth for the periods indicated information for the
Bank with respect to average balances of assets and liabilities, as well as the
total dollar amounts of interest income from interest earning assets and
interest expense on interest bearing liabilities, resultant yields or costs, net
interest income, net interest spread, net interest margin and the ratio of
average interest earning assets to average interest bearing liabilities. The
average loan balances presented in the table are net of allowances for loan
losses. Nonaccrual loans have been included in the tables as loans carrying a
zero yield.
Three Months Ended December 31,
----------------------------------------------------------
1996 1997
---------------------------------------------------------
INTEREST INTEREST
AVERAGE EARNED/ AVERAGE AVERAGE EARNED/ AVERAGE
BALANCE PAID RATE BALANCE PAID RATE
----------------------------------------------------------
($ in thousands)
INTEREST EARNING ASSETS:
Loans $174,558 4,060 9.30% 209,083 4,857 9.29%
Mortgage backed securities 5,735 117 8.21% 4,815 102 8.43%
Investment securities and
FHLB stock 13,852 206 5.94% 9,232 142 6.17%
Interest earning deposits 15,560 208 5.34% 19,658 279 5.67%
----------------------------------------------------------
Total interest earning assets 209,705 4,591 8.76% 242,788 5,380 8.86%
Noninterest earning assets 19,094 22,012
-------- -------
Total assets 228,799 264,800
======== =======
INTEREST BEARING LIABILITIES
Certificates of deposit 118,970 1,671 5.62% 128,004 1,792 5.60%
Savings accounts 30,022 268 3.57% 40,035 382 3.82%
Interest bearing demand deposits 41,345 331 3.21% 49,099 397 3.23%
----------------------------------------------------------
Total interest bearing deposits 190,337 2,270 4.77% 217,138 2,571 4.73%
FHLB advances - - - - - -
Other borrowed funds - - - - - -
----------------------------------------------------------
Total interest bearing liabilities 190,337 2,270 4.77% 217,138 2,571 4.73%
Demand and other noninterest
bearing deposits 7,689 15,826
Other noninterest bearing 4,620 3,727
liabilities
Stockholders' equity 26,153 28,109
-------- -------
Total liabilities and
stockholders' equity $228,799 264,800
======== =======
Page 11
Net interest income $ 2,321 $ 2,809
Net interest spread 3.99% 4.13%
Net interest margin 4.43% 4.63%
Average interest earning assets 110.18% 111.81%
to average interest bearing
liabilities
Six Months Ended December 31,
---------------------------------------------------------
1996 1997
---------------------------------------------------------
INTEREST INTEREST
AVERAGE EARNED/ AVERAGE AVERAGE EARNED/ AVERAGE
BALANCE PAID RATE BALANCE PAID RATE
---------------------------------------------------------
($ in thousands)
INTEREST EARNING ASSETS:
Loans $171,909 7,955 9.25% 207,912 9,599 9.23%
Mortgage backed securities 5,808 240 8.26% 4,929 208 8.45%
Investment securities and
FHLB stock 14,475 445 6.15% 9,543 296 6.20%
Interest earning deposits 15,431 410 5.31% 11,578 327 5.64%
---------------------------------------------------------
Total interest earning assets 207,623 9,050 8.72% 233,962 10,430 8.92%
Noninterest earning assets 18,884 20,794
-------- -------
Total assets 226,507 254,756
======== =======
INTEREST BEARING LIABILITIES
Certificates of deposit 117,713 3,324 5.65% 126,546 3,528 5.58%
Savings accounts 30,001 536 3.57% 35,279 656 3.72%
Interest bearing demand deposits 40,632 656 3.23% 48,449 784 3.24%
---------------------------------------------------------
Total interest bearing deposits 188,346 4,516 4.80% 210,274 4,968 4.73%
FHLB advances - - - 243 8 6.22%
Other borrowed funds - - - - - -
---------------------------------------------------------
Total interest bearing liabilities 188,346 4,516 4.80% 210,517 4,976 4.73%
Demand and other noninterest
bearing deposits 7,201 12,668
Other noninterest bearing 5,110 3,763
liabilities
Stockholders' equity 25,850 27,808
-------- -------
Total liabilities and
stockholders' equity $226,507 254,756
======== =======
Net interest income $4,534 $ 5,454
Net interest spread 3.92% 4.19%
Net interest margin 4.37% 4.66%
Average interest earning assets 110.23% 111.14%
to average interest bearing
liabilities
RATE/VOLUME ANALYSIS
The following table sets forth the amounts of the changes in the Bank's net
interest income attributable to changes in volume and changes in interest rates.
Changes
Page 12
attributable to the combined effect of volume and interest rates have been
allocated proportionately to changes due to volume and the changes due to
interest rates.
Three Months Ended December 31,
-----------------------------------
1996 Compared to 1997
-----------------------------------
Volume Rate Total
-----------------------------------
Loans $ 802 (5) 797
Mortgage backed securities (18) 3 (15)
Investment securities and FHLB stock (72) 8 (64)
Interest earning deposits 58 13 71
-----------------------------------
Total interest income 770 19 789
===================================
Certificates of deposit (126) 5 (121)
Savings accounts (96) (18) (114)
Interest bearing demand deposits (63) (3) (66)
-----------------------------------
Total interest on deposits (285) (16) (301)
FHLB Advances - - -
Other borrowed funds - - -
-----------------------------------
Total Interest Expense $(285) (16) (301)
===================================
Six Months Ended December 31,
-----------------------------------
1996 Compared to 1997
-----------------------------------
Volume Rate Total
-----------------------------------
Loans $1,665 (21) 1,644
Mortgage backed securities (37) 5 (32)
Investment securities and FHLB stock (151) 2 (149)
Interest earning deposits (102) 19 (83)
-----------------------------------
Total interest income 1,375 5 1,380
===================================
Certificates of deposit (249) 45 (204)
Savings accounts (94) (26) (120)
Interest bearing demand deposits (126) (2) (128)
-----------------------------------
Total interest on deposits (469) 17 (452)
FHLB Advances (8) - (8)
Other borrowed funds - - -
-----------------------------------
Total Interest Expense $ (477) 17 (460)
===================================
ASSET QUALITY
Nonperforming Assets
The following table sets forth the amount of the Bank's nonperforming assets at
the dates indicated.
At June 30, At December 31,
1997 1997
===============================
(Dollars in thousands)
Nonaccrual loans $ 133 344
Restructured loans - -
-------------------------------
Total nonperforming loans 133 344
Page 13
Real Estate owned - -
-------------------------------
Total nonperforming assets $ 133 344
===============================
Accruing loans past due 90 days or more $ - -
Potential problem loans 68 126
Allowance for loan losses 2,752 2,812
Nonperforming loans to loans 0.06% 0.16%
Allowance for loan losses to loans 1.32% 1.30%
Allowance for loan losses to nonperforming loans 2,069.17% 817.44%
Nonperforming assets to total assets 0.05% 0.10%
At both dates shown in the table above, the nonaccrual loans were comprised of
single family mortgages.
ANALYSIS OF ALLOWANCE FOR LOAN LOSSES
The allowance for loan losses is maintained at a level considered adequate by
management to provide for reasonably foreseeable loan losses based on
management's assessment of various factors affecting the loan portfolio,
including a review of problem loans, business conditions and loss experience and
an overall evaluation of the quality of the underlying collateral, holding and
disposal costs and costs of capital. The allowance is increased by provisions
for loan losses charged to operations and reduced by loans charged off, net of
recoveries.
While management believes that it uses the best information available to
determine the allowance for loan losses, unforeseen market conditions could
result in adjustments to the allowance for loan losses, and net income could be
significantly affected, if circumstances differ substantially from the
assumptions used in determining the allowance.
The following table sets forth for the periods indicated information regarding
changes in the Bank's allowance for loan losses:
Six Months Ended December 31,
-----------------------------
1996 1997
-----------------------------
Total loans outstanding at end of period (1) $180,592 215,491
Average loans outstanding during period 173,781 210,690
Allowance balance at beginning of period 1,873 2,752
Provision for loan losses - 60
Charge-offs
Real estate - -
Commercial (3) -
Consumer - -
-----------------------------
Total charge-offs (3) -
-----------------------------
Recoveries
Real estate - -
Commercial - -
Consumer - -
Page 14
--------------------------
Total recoveries - -
--------------------------
Net (charge-offs) recoveries (3) -
--------------------------
Allowance balance at end of period $ 1,870 2,812
==========================
Ratio of net (charge-offs) recoveries during
period to average loans outstanding 0.001% - %
==========================
__________
(1) Includes loans held for sale
COMPARISON OF OPERATING RESULTS FOR THE THREE MONTHS ENDED
DECEMBER 31, 1997 AND 1996
NET INCOME The Bank's net income increased $134,000, or 26%, to $646,000 for
the three months ended December 31, 1997 as compared to $512,000 for the three
months ended December 31, 1996. This increase was attributable to an increase in
net interest income partially offset by an increase in noninterest expense.
NET INTEREST INCOME Net interest income increased $488,000, or 21%, to $2.8
million for the three months ended December 31, 1997, compared to $2.3 million
for the comparable 1996 quarter. The increase was primarily due to a $33.1
million, or 16%, increase in the average balance of earning assets resulting
from a $34.5 million increase in the average balance of loans and a decline in
the other interest earning assets.
At December 31, 1997, the Bank held stock subscription funds amounting to $72.5
million which were invested in interest earning deposits. The Bank paid the
subscribers for these funds at the passbook savings rate from the date of
deposit through the closing (January 8, 1998). These stock subscription funds
caused the average balance of interest earning deposits and savings deposits to
increase by $14.4 million for the three months ended December 31, 1997. The
earnings from the escrow of these stock subscription funds caused net income for
the three months ended December 31, 1997 to increase $64,000.
Net interest margin for the three months ended December 31, 1997 increased to
4.63% from 4.43% for the same period in 1996. The increase in margin was
attributable to growth in loans, particularly commercial loans, coupled with a
slight decrease in the average cost of interest bearing deposits, particularly
certificates of deposit.
PROVISION FOR LOAN LOSSES The provision for loan losses for the three months
ended December 31, 1997 was $30,000. There was no provision for loan losses
during the same period in 1996. The allowance for loan losses at December 31,
1997 was $2.8 million, or 1.30% of loans. At December 31, 1997, management
determined that the allowance for loan losses was adequate to cover reasonably
foreseeable losses in the Bank's loan portfolio.
Page 15
NONINTEREST INCOME Noninterest income for the three months ended December 31,
1997 increased $34,000, or 4%, compared with the 1996 comparable period. Gains
on sales of loans increased $23,000, or 4%, as a result of the volume of loans
sold having increased by 23% ($23.2 million in 1997 quarter compared to $18.8
million in the 1996 quarter) while the average gain declined to 2.42% in the
1997 quarter compared to 2.85% in the comparable 1996 quarter. Service charges
on deposit increased $12,000, or 10%, due to growth in business and personal
checking accounts.
NONINTEREST EXPENSE Noninterest expense for the three months ended December
31, 1997 increased $268,000, or 11%, compared with the same period in 1996. The
increase was attributable to the Bank's expansion of its branch capacity in
Pierce County and the continued development of the Bank's relationship banking
capacity. Salaries and employee benefits increased $133,000, or 10%, resulting
from higher mortgage commissions on increased mortgage lending volumes, two
additions to Pierce County personnel and lower capitalized loan costs due to a
lower volume of construction loans originated during the 1997 quarter. The
staff additions were at the Pierce County Business Banking Center which opened
in February 1997. Occupancy expense rose $34,000, or 8%, as a result of rent
and other operating costs at the Pierce County Business Banking Center and the
construction of a walk-up ATM at the 80th & Pacific Branch in January 1997.
Data processing increased $39,000, or 28%, as a result of offering new products,
supporting the Pierce County expansion, and increased costs of service.
Marketing expenses increased $43,000, or 80%, resulting from the promotion of
Heritage's expansion into Pierce County, new products offered, and the
recognition of the Bank's 70th anniversary.
COMPARISON OF OPERATING RESULTS FOR THE SIX MONTHS ENDED
DECEMBER 31, 1997 AND 1996
NET INCOME Net income for the six months ended December 31, 1997 was $1.3
million, or $0.69 per share, compared with $1.2 million, or $0.68 per share, for
the comparable 1996 period. During the quarter ended September 30, 1996, based
on federal legislation, the Bank accrued $1.1 million for a one-time special
assessment by the FDIC to recapitalize the SAIF deposit insurance fund. The Bank
also reversed a $938,000 deferred tax liability related to the potential
recapture of the pre-1988 additions to the tax bad debt reserve. Excluding the
impact of these two nonrecurring items, net income for the six months ended
December 31, 1996 would have been $1.0 million, or $0.56 per share. On a
comparable fully taxed basis, net income for the six months ended December 31,
1997 increased by $247,000, or 24%, compared with the first six months of 1996.
The increase in net income on such a comparable basis was primarily attributable
to an increase in net interest income partially offset by an increase in
noninterest expense.
Page 16
NET INTEREST INCOME Net interest income increased $920,000, or 20%, to $5.5
million for the six months ended December 31, 1997 compared to $4.5 million for
the six months ended December 31, 1996. The increase was primarily due to a
$26.3 million, or 13%, increase in the average balance of earning assets
resulting from a $36.0 million increase in the average balance of loans and a
decline in other interest earning assets.
Net interest margin for the six months ended December 31, 1997 increased to
4.66% from 4.37% for the same period in 1996. The increase in margin was
attributable to growth in assets and a shift from lower yielding investments,
interest earning deposits and mortgage backed securities into higher yielding
loans, particularly commercial loans, coupled with a decrease in the average
cost of interest bearing deposits, particularly certificates of deposit.
PROVISIONS FOR LOAN LOSSES The provision for loan losses for the six months
ended December 31, 1997 was $60,000. There was no provision for loan losses
during the same period in 1996.
NONINTEREST INCOME The Bank recorded a $61,000, or 4%, increase in
noninterest income for the six months ended December 31, 1997 compared to the
same period in 1996. In August 1997, the Bank recognized income of $36,000 from
a settlement with a title company concerning a boundary line adjustment at the
Bank's Spanaway branch. Service charges on deposits increased $24,000, or 10%,
due to growth in business and personal checking accounts.
NONINTEREST EXPENSE Excluding the impact of the $1.1 million one-time SAIF
assessment which the Bank accrued in September 1996, noninterest expense
increased $506,000, or 11%, to $5.2 million for the six months ended December
31, 1997 compared with $4.7 million for the same period in 1996. Salaries and
employee benefits increased $291,000, or 11%, as a result of hiring two
experienced commercial lending officers in Pierce County and branch staff for
the two Pierce County branches opened in October 1996 and February 1997. The
remaining increase in salaries and employee benefits was primarily attributable
to lower capitalized loan costs during the six months ended December 31, 1997
due to a lower volume of mortgage and construction loans originated. Occupancy
increased $83,000, or 11%, due to the operating costs of the two Pierce County
branch facilities opened after September 1996. Excluding the special SAIF
assessment, FDIC premiums decreased $75,000, or 54%, as the FDIC reduced the
Bank's federal deposit premiums from 0.23% (on an annualized basis) of insured
deposits for the quarter ended September 30, 1996 to 0.06% of insured deposits
for the period beginning January 1, 1997. Data processing increased $66,000, or
26%, as a result of offering new products, supporting the Pierce County
expansion, and increased costs of service. Marketing expenses increased
$83,000, or 85%, resulting from the promotion of Heritage's expansion into
Pierce County, new products offered, and the recognition of the Bank's 70th
anniversary.
INCOME TAXES Provision for federal income taxes was $691,000 for the six
months ended December 31, 1997, compared to a federal income tax benefit of
Page 17
$785,000 for the same period in 1996. The federal income tax benefit for the
1996 period reflects the reversal of the $938,000 deferred tax liability
mentioned above.
LIQUIDITY AND CAPITAL RESOURCES
The Bank's primary sources of funds are customer deposits, loan repayments, loan
sales, maturing investment securities and advances from the FHLB of Seattle.
These funds, together with retained earnings, equity and other borrowed funds,
are used to make loans, acquire investment securities and other assets and to
fund continuing operations. While maturities and scheduled amortization of
loans are a predictable source of funds, deposit flows and mortgage prepayments
are greatly influenced by the level of interest rates, economic conditions and
competition.
The Bank must maintain an adequate level of liquidity to ensure the availability
of sufficient funds to fund loan originations and deposit withdrawals, to
satisfy other financial commitments and to fund operations. The Bank generally
maintains sufficient cash and short term investments to meet short term
liquidity needs. At December 31, 1997, cash and cash equivalents totaled $87.8
million, or 27% of total assets, and investment securities classified as held to
maturity with maturities of one year or less amounted to $4.2 million, or 1.3%
of total assets. At December 31, 1997, the Bank maintained an unused credit
facility with the FHLB of Seattle for up to 20% of assets or $65.7 million.
To fund the growth of the Bank, management's strategy has been to build core
deposits (which the Bank defines to include all deposits except public funds)
through the development of its branch office network and commercial banking
relationships. Historically, the Bank has been able to retain a significant
amount of its deposits as they mature. Management anticipates that the Bank
will continue to rely on the same sources of funds in the future and will use
those funds primarily to make loans and purchase investment securities.
Heritage Bank is subject to certain regulatory capital requirements. At
December 31, 1997, the Bank was classified as a "well capitalized" institution
under the criteria established by the FDIC Act. See Note 2 to the financial
statements for regulatory capital compliance at December 31, 1997. Effective
January 8, 1998, the Company closed its second step conversion and stock
offering which resulted in $66.1 million in gross proceeds.
IMPACT OF INFLATION AND CHANGING PRICES
The primary impact of inflation on the Bank's operations is increased operating
costs. Unlike most industrial companies, virtually all the assets and
liabilities of a financial institution are monetary in nature. As a result,
interest rates generally have a more significant impact on a financial
institution's performance than the effects of general levels of inflation.
Although interest rates do not necessarily move in the same direction or to the
same extent as the prices of goods and services, increases in inflation
generally have resulted in increased interest rates.
Page 18
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income".
SFAS 130 establishes standards for reporting comprehensive income and its
components (revenues, expenses, gains and losses) in a full set of financial
statements. This Statement requires that the Bank (a) classify items of other
comprehensive income by their nature in its financial statements and (b) display
the accumulated balance of other comprehensive income separately from retained
earnings and additional paid-in capital in the equity section of the statement
of financial condition. This statement is effective for the year ending June
30, 1999.
In June 1997, the FASB issued SFAS No. 131, "Disclosure about Segments of an
Enterprise and Related Information". SFAS 131 requires public companies to
report financial and descriptive information about its operating segments.
Operating segments are components of a business about which separate financial
information is available that is evaluated regularly by the chief operating
decision-maker in deciding how to allocate resources and in assessing
performance. The adoption of SFAS 131 is required for the fiscal year ended
June 30, 1999 and the Bank is currently evaluating the effect of this Statement.
YEAR 2000 ISSUES
The Bank utilizes various computer software programs to provide banking products
and services to its customers. Many existing computer programs use only two
digits to identify a year in the date field and were not designed to consider
the impact of the upcoming change in the century. If not corrected, many
computer applications could fail or create erroneous results by or at the Year
2000. The Year 2000 issue affects virtually all companies and organizations.
The Bank has identified all computer software programs used in its business and
has determined the extent to which these programs are Year 2000 compliant. The
Bank utilizes a service bureau to perform data processing services related to
the Bank's loans, deposits, general ledger and other financial applications.
The Bank's service bureau advised the Bank that it has committed resources to
perform and test necessary modifications by December 31, 1998.
The Bank utilizes other computer software in its daily operations from automated
heating, air conditioning and ventilating systems to its telephone and voice
mail systems. The modification and testing of these software programs will not
have a material impact on the Bank's financial condition.
HERITAGE FINANCIAL CORPORATION
FORM 10-Q
PART II. OTHER INFORMATION
Page 19
ITEM 6. EXHIBITS AND REPORTS OF FROM 8-K
a. See EXHIBIT 27-Financial Data Schedule
b. No reports on Form 8K were filed during the quarter ended December 31,
1997.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
HERITAGE FINANCIAL CORPORATION
------------------------------------
(Registrant)
Date: February 13, 1998 by /s/ Donald V. Rhodes
------------------------------------
Donald V. Rhodes, Chairman, President
and Chief Executive Officer
(Duly Authorized Officer)
Date: February 13, 1998 by /s/ James Hastings
------------------------------------
James Hastings, Vice President
and Treasurer
(Principal Financial and
Accounting Officer)
Page 20