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 September 30, 1998
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 0-29480
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 November 3, 1998 there were outstanding 9,907,444 common shares, with no
par value, of the registrant.
Page 1
HERITAGE FINANCIAL CORPORATION
FORM 10-Q
INDEX
PART I. Financial Information
- ------- ---------------------
Item 1. Condensed Consolidated Financial Statements (Unaudited): Page
----
Consolidated Statements of Income for the Three 3
Months Ended September 30, 1997 and 1998
Consolidated Statements of Financial Condition 4
As of June 30, 1998 and September 30, 1998
Consolidated Statements of Stockholders' Equity and 5
Comprehensive Income for the Three Months Ended
September 30, 1998
Consolidated Statements of Cash Flows for the 6
Three Months Ended September 30, 1997 and 1998
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of 9
Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk 14
PART II. Other Information
Item 6. Exhibits and Reports on Form 8-K 16
Signatures 17
Page 2
HERITAGE FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except for per share data)
(unaudited)
Three Months Ended
September 30,
---------------------
1997 1998
---- ----
INTEREST INCOME :
Loans $4,742 6,531
Mortgage backed securities 107 78
Investment securities and FHLB dividends 153 513
Interest bearing deposits 48 694
------ -----
Total interest income 5,050 7,816
INTEREST EXPENSE :
Deposits 2,398 3,120
Borrowed funds 8 24
------ -----
Total interest expense 2,406 3,144
------ -----
Net interest income 2,644 4,672
PROVISION FOR LOAN LOSSES 30 90
------ -----
Net interest income after provision for loan loss 2,614 4,582
NONINTEREST INCOME :
Gains on sales of loans 542 588
Commissions on sales of annuities
and securities 52 32
Service charges on deposits 121 215
Rental income 52 63
Other income 127 242
------ -----
Total noninterest income 894 1,140
NONINTEREST EXPENSE :
Salaries and employee benefits 1,468 1,969
Building occupancy 423 588
Data processing 147 196
Marketing 85 126
Goodwill Amortization - 144
Other 440 700
------ -----
Total noninterest expense 2,563 3,723
------ -----
Income before federal income tax 945 1,999
Federal income tax 335 722
------ -----
Net income $ 610 1,277
====== =====
Earnings per share :
Basic $ 0.07 0.13
Diluted $ 0.06 0.13
See Notes to Condensed Consolidated Financial Statements
Page 3
HERITAGE FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands)
June 30, September 30,
1998 1998
----------------------------
Assets (Unaudited)
Cash on hand and in banks $ 12,065 12,361
Interest earning deposits 50,542 50,560
Federal funds sold 12,000 5,500
Investment securities available for sale 9,041 10,105
Investment securities held to maturity 25,887 18,398
Mortgage backed securities held to maturity 3,844 3,596
Loans held for sale 6,411 5,995
Loans receivable 269,355 284,425
Less: Allowance for loan losses (3,542) (3,626)
----------------------------
Loans, net 265,813 280,799
Real Estate Owned 82 -
Premises and equipment, net 15,923 16,298
Federal Home Loan Bank stock 1,985 2,023
Accrued interest receivable 2,275 2,338
Prepaid expenses and other assets 1,352 1,440
Goodwill 8,631 8,487
----------------------------
$415,851 417,900
============================
Liabilities and Stockholders' Equity
Deposits 314,120 314,216
Advances from Federal Home Loan Bank 698 693
Other borrowings 1,132 894
Advance payments by borrowers for taxes and insurance 419 677
Accrued expenses and other liabilities 4,412 4,991
Deferred Federal income taxes 1,183 1,198
----------------------------
321,964 322,669
Stockholders' equity:
Common stock, no par value per share,15,000,000 shares authorized;
9,656,176 shares and 9,776,292 outstanding, respectively 70,515 70,962
Unearned compensation ESOP and Other (1,328) (1,306)
Retained earnings, substantially restricted 24,696 25,543
Accumulated other comprehensive income 4 32
----------------------------
Total stockholders' equity 93,887 95,231
Commitments and contingencies
----------------------------
$415,851 417,900
============================
See Notes to Condensed Consolidated Financial Statements
Page 4
HERITAGE FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
Three Months Ended September 30, 1998
(Dollars in Thousands)
(Unaudited)
Number Unearned Accumulated
of compensation other Total
common Common ESOP and Retained comprehensive stockholders'
shares stock other earnings income equity
-----------------------------------------------------------------------------------------
Balance at June 30, 1998 9,656 $70,515 (1,328) 24,696 4 93,887
Earned ESOP shares - 3 22 - - 25
Exercise of stock options 120 444 - - - 444
Net income - - - 1,277 - 1,277
Increase in unrealized gain on
securities available for sale,
net of tax - - - - 28 28
Cash dividend declared - - - (430) - (430)
-----------------------------------------------------------------------------------------
Balance at Sept 30, 1998 9,776 $70,962 (1,306) 25,543 32 95,231
=========================================================================================
Three months ended
Comprehensive Income September 30,
-----------------------
1997 1998
-----------------------
Net income $ 610 $1,277
Increase in unrealized gain on securities
available for sale, net of tax - 28
-----------------------
Comprehensive income $ 610 $1,305
=======================
See Notes to Condensed Consolidated Financial Statements
Page 5
HERITAGE FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)
Three Months
Ended
September 30,
--------------------
1997 1998
---- ----
Cash flows from operating activities:
Net income $ 610 1,277
Adjustments to reconcile net income to net cash
provided by operating activities
Amortization of goodwill - 144
Depreciation and amortization 252 186
Deferred loan fees, net of amortization (56) -
Provision for loan losses 30 90
Net decrease in loans held for sale 872 416
Federal Home Loan Bank stock dividends (30) (37)
Sale of real estate owned - 82
Recognition of compensation related to ESOP - 26
Net change in accrued interest receivable, prepaid
expenses and other assets, and accrued expenses and
other liabilities (1,283) 539
--------------------
Net cash provided by operating activities 394 2,723
--------------------
Cash flows from investing activities:
Loans originated, net of principal payments and loan sales (2,883) (15,076)
Principal payments of mortgage backed securities 235 249
Proceeds from maturities of investment securities held to maturity 570 7,500
Purchase of investment securities available for sale - (1,033)
--------------------
Purchase of premises and equipment (98) (718)
Net cash used in investing activities (2,176) (9,078)
--------------------
Cash flows from financing activities:
Net increase in deposits 7,167 96
Net decrease in borrowed funds (890) (243)
Net increase in advance payment by borrowers for taxes
and insurance 315 258
Cash dividends paid - (386)
Proceeds from exercise of stock options - 444
--------------------
Net cash provided by financing activities 6,592 169
--------------------
Net increase (decrease) in cash and cash equivalents 4,810 (6,186)
Cash and cash equivalents at beginning of period 7,587 74,607
--------------------
Cash and cash equivalents at end of period $12,397 68,421
====================
Supplemental disclosures of cash flow information:
Cash payments for:
Interest expense $ 2,444 3,128
Federal income taxes - 410
See Notes to Condensed Consolidated Financial Statements
Page 6
HERITAGE FINANCIAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three Months Ended September 30, 1998 and 1997
(Unaudited)
NOTE 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
(a.) Description of Business
Heritage Financial Corporation (the "Company") was organized in August 1997 as
the holding company for Heritage Savings Bank (the "Bank"). Effective January 8,
1998, the Company closed its second step conversion and stock offering which
resulted in $63 million in net 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.
(b.) Basis of Presentation
The financial statements shown herein are for the Bank only through December 31,
1997 and for the consolidated Company thereafter. 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 Company's June 30,
1998 audited consolidated financial statements and notes thereto included in the
Company's Annual Report on Form 10-K and the 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
adjustments) considered necessary for a fair presentation have been included.
Operating results for the three months ended September 30, 1998 are not
necessarily indicative of the results that may be expected for the year ended
June 30, 1999. 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 statements of financial
condition, 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.
Page 7
b.) Earnings per Share
The following tables illustrate the reconciliation of weighted average shares
used for earnings per share for the applicable periods.
Three months ended September 30,
1997 1998
---------------------------------
Basic:
1,809,616 9,708,441
Weighted average shares 7,508,459 -
Effect of stock conversion ---------------------------------
Weighted average shares outstanding 9,318,075 9,708,441
=================================
Diluted:
9,318,075 9,708,441
Basic weighted average share outstanding 91,607 298,621
Incremental shares from stock options ---------------------------------
Weighted average shares outstanding 9,409,682 10,007,062
=================================
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 multiplied by the exchange ratio utilized in the stock
conversion (5.1492). On January 8, 1998, the former stockholders of the Bank
received 5.1492 shares of the Company's common stock for each share of the
Bank's common stock exchanged.
c. Cash Dividend Declared
On September 21, 1998, the Company announced a quarterly cash dividend of 4.5
cents per share payable on October 15, 1998 to shareholders of record on October
6, 1998.
Page 8
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion is intended to assist in understanding the financial
condition and results of operations of the Company. The information contained
in this section should be read in conjunction with the Condensed Financial
Statements and the accompanying Notes thereto and the June 30, 1998 audited
consolidated financial statements and notes thereto included in the Company's
recent Annual Report on Form 10-K and the Registration Statement on Form S-1
filed with the Securities and Exchange Commission under file number 333-35573.
STATEMENTS CONCERNING FUTURE PERFORMANCE, DEVELOPMENTS OR EVENTS, CONCERNING
EXPECTATIONS FOR GROWTH AND MARKET FORECASTS, AND ANY OTHER GUIDANCE ON FUTURE
PERIODS, CONSTITUTE FORWARD-LOOKING STATEMENTS WHICH ARE SUBJECT TO A NUMBER OF
RISKS AND UNCERTAINTIES WHICH MIGHT CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY
FROM STATED EXPECTATIONS. SPECIFIC FACTORS INCLUDE, BUT ARE NOT LIMITED TO THE
EFFECT OF INTEREST RATE CHANGES, RISKS ASSOCIATED WITH ACQUISITION OF OTHER
BANKS AND OPENING NEW BRANCHES, THE ABILITY TO CONTROL COSTS AND EXPENSES, AND
GENERAL ECONOMIC CONDITIONS. ADDITIONAL INFORMATION ON THESE AND OTHER FACTORS
WHICH COULD AFFECT THE COMPANY'S FINANCIAL RESULTS ARE INCLUDED IN FILINGS BY
THE COMPANY WITH THE SECURITIES AND EXCHANGE COMMISSION.
Overview
Beginning in 1994, the Company 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. Effective January 8, 1998, the Company closed its second step
conversion and stock offering which resulted in $63 million in net proceeds.
Thereafter, the Company's common stock began to trade on the Nasdaq National
Market under the symbol "HFWA". The Company 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.
Financial Condition Data
The Company's total assets and deposits at September 30, 1998 reached $417.9
million and $314.2 million, respectively. Both categories showed slight
increases over June 30, 1998 due to the one time withdrawal of approximately $17
million in temporary funds which were deposited in June 1998. Excluding the
impact of this $17 million withdrawal, total assets and deposits rose 5% and 6%,
respectively, during the three months ended September 30, 1998. Net loans
(including loans held for sale) increased $14.6 million, or 5%, to $286.8
million from June 30, 1998. Commercial loans increased to $107.3 million at
September 30, 1998, compared with $100.5 million at June 30, 1998, an increase
of 7%.
Page 9
Earnings Summary
Net income for the three months ended September 30, 1998 was $1.3 million, or
$0.13 per diluted share, compared to $610,000, or $0.06 per diluted share, for
the same period last year, an increase of 109%. The increase in net income was
primarily attributable to a $143 million increase in the average balance of
earning assets. The majority of the increase in earning assets resulted from
the acquisition of North Pacific Bank in June 1998 and the influx of $63 million
in net proceeds from the Company's January 1998 stock offering.
Net Interest Income
Net interest income for the three months ended September 30, 1998 increased 77%
to $4.7 million from $2.6 million for the same quarter of fiscal 1998. This
increase in net interest income was predominately due to a $143 million, or 63%,
increase in the average balance of earning assets for the current quarter versus
the same quarter last year.
Net interest margin (net interest income divided by average interest earning
assets) widened to 5.08% for the current quarter from 4.70% for the same
quarter last year and from 4.99% for the quarter ended June 30, 1998. The
increase in net interest margin reflects the substantial influx in equity
capital from the January 1998 stock offering and the impact of the acquisition
of North Pacific Bank. North Pacific Bank's earning assets had a higher net
interest margin for the current quarter (approximately 6.28%) than Heritage
Bank's earning assets. Despite the improved net interest margin, the Company
continues to experience downward pressure on lending spreads due to increased
competition and the shape of the yield curve. While net interest margin
widened, net interest spread declined to 3.99% for the current quarter from
4.25% for the three months ended September 30, 1997. The average yield of
earning assets decreased to 8.50% for the current quarter from 8.97% for the
same quarter last year due to the investment of the stock offering net proceeds
in lower yielding assets as management seeks to deploy the funds in higher
yielding loans. However, the average yield on loans increased to 9.39% for the
September 1998 quarter from 9.18% for the September 1997 quarter due to the
Company's focus on increasing commercial loans in its overall loan mix.
Similarly, the Company's cost of funds has decreased to 4.51% for the current
quarter from 4.72% for the September 1997 quarter due to the increase in lower
costing deposits, primarily savings, interest bearing demand and money market
accounts. This structural shift in deposit mix is part of the Company's
strategy to increase its emphasis on commercial banking relationships and to
reduce its dependency on certificates of deposit. The implementation of the
increased emphasis on commercial banking relationships was enhanced by the
acquisition of North Pacific Bank.
Provision for Loan Losses
The Company increased the provision for loan losses to $90,000 for the current
quarter from $30,000 for the September 1997 quarter in order to maintain its
allowance for loan losses at an adequate level during a time of change in loan
portfolio composition and loan growth.
Page 10
Noninterest Income
Noninterest income for the three months ended September 30, 1998 increased
$246,000, or 28%, to $1.1 million from $894,000 for the September 1997 quarter.
The majority of this increase ($209,000) was in the categories of service
charges on deposits and other income which experienced substantial growth due to
the addition of North Pacific Bank's fee and other income generating activities
and the growth in Heritage Bank's deposit service charge income. Gains on sales
of loans increased $46,000, or 8%, to $588,000 in the current quarter from
$542,000 for the same period last year as a result of the increased volume of
mortgage loans sold during the current quarter.
Noninterest Expense
Noninterest expense for the September 1998 quarter increased $1.16 million, or
45%, to $3.7 million from $2.6 million for the September 1997 quarter. Of this
$1.16 million increase, approximately $1 million was attributable to the
inclusion of the ongoing operations of North Pacific Bank and the $144,000
amortization of goodwill for the North Pacific Bank acquisition. The remaining
$160,000 increase primarily reflects increases in data processing, marketing
and other expenses related to business growth and expansion in Pierce County.
The Company's efficiency ratio (noninterest expense as a percentage of the sum
of net interest income and noninterest income) improved to 64% for the quarter
ended September 30, 1998 from 72% for the September 1997 quarter.
Lending Activities
Since initiating its expansion activities in 1994, the Company has supplemented
its traditional mortgage loan products with an increased emphasis on commercial
loans. As indicated in the table below, total loans increased to $290.4 million
at September 30, 1998 from $275.8 million at June 30, 1998. At September 30,
1998, commercial loans increased to $107.3 million, or 36.95% of total loans,
from $100.5 million, or 36.44% of total loans, at June 30, 1998.
(in thousands)
At June 30, % of At Sept 30, % of
1998 Total 1998 Total
---------------------------------------------
Commercial $100,489 36.44% $107,313 36.95%
Real estate mortgages
One-to-four family residential 97,598 35.39 97,890 33.70
Five or more family and commercial
properties 57,158 20.73 60,524 20.84
---------------------------------------------
Total real estate mortgages 154,756 56.12 158,414 54.54
Real estate construction
One-to-four family residential 18,192 6.60 21,552 7.42
Five or more family and commercial
properties 527 0.19 1,155 0.40
---------------------------------------------
Total real estate construction 18,719 6.79 22,707 7.82
Consumer 3,030 1.10 3,214 1.11
---------------------------------------------
Gross loans 276,994 100.45% 291,648 100.42%
Less: deferred loan fees (1,228) (0.45) (1,228) (0.42)
---------------------------------------------
Total loans $275,766 100.00% $290,420 100.00%
=============================================
Page 11
Nonperforming Assets
The following table sets forth the amount of the Bank's nonperforming assets at
the dates indicated.
At June 30, At Sept 30,
1998 1998
===========================
(Dollars in thousands)
Nonaccrual loans $ 369 392
Restructured loans - -
---------------------------
Total nonperforming loans 369 392
Real estate owned 82 -
---------------------------
Total nonperforming assets $ 451 392
===========================
Accruing loans past due 90 days or more $ 15 17
Potential problem loans 1,069 743
Allowance for loan losses 3,542 3,626
Nonperforming loans to loans 0.13% 0.13%
Allowance for loan losses to loans 1.28% 1.25%
Allowance for loan losses to nonperforming loans 959.89% 925.00%
Nonperforming assets to total assets 0.11% 0.09%
Nonperforming loans increased to $392,000, or 0.13% of total loans, at September
30, 1998 from $369,000, or 0.13% of total loans, at June 30, 1998.
Nonperforming assets at September 30, 1998 amounted to $392,000, or 0.09% of
total assets. At September 30, 1998, approximately $34,000 of the nonaccrual
loans were commercial loans with collateral other than real estate.
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.
Page 12
The following table sets forth for the periods indicated information regarding
changes in the Company's allowance for loan losses:
Three Months Ended September 30,
1997 1998
-------------------------------
Total loans outstanding at end of period (1) $210,260 290,420
Average loans outstanding during period 209,505 281,611
Allowance balance at beginning of period 2,752 3,542
Provision for loan losses 30 90
Charge-offs
Real estate - (12)
Commercial - -
Consumer - -
Total charge-offs - (12)
-------------------------------
Recoveries
Real estate - 6
Commercial - -
Consumer - -
-------------------------------
Total recoveries - 6
-------------------------------
Net (charge-offs) recoveries - (6)
-------------------------------
Allowance balance at end of period $ 2,782 3,626
===============================
Ratio of net (charge-offs) recoveries during
period to average loans outstanding 0.000% (0.002%)
===============================
__________
(1) Includes loans held for sale
While pursuing its growth strategy, the Company will continue to employ prudent
underwriting and sound loan monitoring procedures in order to maintain asset
quality. The allowance for loan losses at September 30, 1998 increased $84,000
to $3.6 million, or 1.25% of total loans. This ratio of allowance for loan
losses to total loans has declined to 1.25% at September 30, 1998 from 1.28% at
June 30, 1998 due to the growth of the loan portfolio.
Liquidity and Source of Funds
The Company'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 Company 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
Company generally maintains sufficient cash and short term investments to meet
short term liquidity needs. At September 30, 1998, cash and cash equivalents
totaled $68.4 million, or 16% of total assets, and investment securities
classified as either available for sale or held to
Page 13
maturity with maturities of one year or less amounted to $8.7 million, or 2.1%
of total assets. At September 30, 1998, the Company maintained a credit facility
with the FHLB of Seattle for up to 20% of assets or $83.6 million (of which only
$693,000 was outstanding at that date).
To fund the growth of the Company, management's strategy has been to build core
deposits (which includes all deposits except public funds) through the
development of its branch office network and commercial banking relationships.
Historically, the Company has been able to retain a significant amount of its
deposits as they mature. Management anticipates that the Company 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.
Capital
Stockholders' equity at September 30, 1998 was $95.2 million compared with $93.9
million at June 30, 1998. In addition to the Company's earnings, proceeds from
the exercise of stock options totaling $444,000 increased stockholders' equity
during the quarter. During the three months ended September 30, 1998, the
Company declared a cash dividend in the amount of $430,000, or 4.5 cents per
share, to shareholders of record on October 6, 1998.
Banking regulations require bank holding companies and banks to maintain a
minimum "leverage" ratio of core capital to adjusted quarterly average total
assets of at least 3%. At September 30, 1998, the Company's leverage ratio was
21.8%, compared with 24.4% at June 30, 1998. In addition, banking regulators
have adopted risk-based capital guidelines, under which risk percentages are
assigned to various categories of assets and off-balance sheet items to
calculate a risk-adjusted capital ratio. Tier I capital generally consists of
common shareholders' equity, while Tier II capital includes the allowance for
loan losses, subject to certain limitations. Regulatory minimum risk-based
capital guidelines require Tier I capital of 4% of risk-adjusted assets and
total capital (combined Tier I and Tier II) of 8%. The Company's Tier I and
total capital ratios were 30.7% and 31.9%, respectively, at September 30, 1998
compared with 31.5% and 32.9%, respectively, at June 30, 1998.
During 1992, the Federal Deposit Insurance Corporation (the "FDIC") published
the qualifications necessary to be classified as a "well-capitalized" bank,
primarily for assignment of FDIC insurance premium rates beginning in 1993. To
qualify as "well-capitalized", banks must have a Tier I risk-adjusted capital
ratio of at least 6%, a total risk-adjusted capital ratio of at least 10%, and
a leverage ratio of at least 5%. Heritage Bank and North Pacific Bank qualified
as "well-capitalized" at September 30, 1998.
Quantitative and Qualitative Disclosures About Market Risk
The Company's results of operations are largely dependent upon its ability to
manage interest rate risk. Management considers interest rate risk to be a
significant market risk that could have a material effect on the Company's
financial condition and results of operations. Neither the Company nor its
subsidiary banks maintain a trading account for any class of financial
instrument, nor do they engage in hedging activities or purchase high risk
derivative instruments. Moreover, neither the Company nor its subsidiary banks
are subject to foreign currency exchange rate risk or commodity price risk.
Page 14
In the opinion of management, there has been no material change in the Company's
interest rate risk exposure since the Company's most recent year end at June 30,
1998.
Year 2000 Issues
The Company 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 following discussion of Year 2000 issues for the Company contains
numerous forward-looking statements based on inherently uncertain information
and management's best estimates. There can be no assurance that these estimates
will be achieved and actual results could differ. The Company places a high
degree of reliance on computer systems of third parties, such as customers and
suppliers. Although the Company is assessing the readiness of these third
parties and preparing contingency plans, there can be no guarantee that the
failure of these third parties to modify their systems in advance of December
31, 1999 would not have a material adverse affect on the Company.
Readiness Preparation
The Company has completed the identification phase in which management has
determined the extent to which all programs used in its business are Year 2000
compliant. Heritage Bank (HB) utilizes a service bureau to perform its most
mission critical data processing services related to its loans, deposits,
general ledger and other financial applications. North Pacific Bank currently
operates an in-house computer system; however, its data processing services will
be transferred to HB's service bureau at the date of the merger of North Pacific
Bank into HB which is expected to close by December 31, 1998. HB's service
bureau has informed HB that it has completed the software programming for 95% of
its applications used by HB, The service bureau has committed the resources to
perform the remaining software modifications by December 31, 1998. Testing of
these service bureau programs has commenced in October 1998 and testing and
implementation are expected to be substantially completed by mid-1999. This
timetable would enable the Company to have its mission critical applications
Year 2000 compliant by July 1999.
The Company has evaluated its major third party business relationships,
including vendors and its borrowers. The Company is also reliant on its
customers to make the necessary preparations for Year 2000 so that their
business operations will not be interrupted, thus threatening their ability to
honor their financial commitments. The Company has analyzed the extent that
Year 2000 issues could adversely impact their borrowers' business operations,
particularly its commercial borrowers. The Company has performed an initial
assessment of each major borrower and has established an ongoing assessment as
part of the Company's credit granting and loan review process.
Cost
Management expects the Company's costs related to Year 2000 issues to
amount to approximately $230,000. Of this total, approximately $43,000 was
incurred in the year ended June
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30, 1998. Of the remaining costs, approximately $165,000 was incurred in October
1998 to replace the existing North Pacific Bank telephone and voice mail system
and modify the existing Heritage Bank telecommunications systems in preparation
for the merger of operations.
Risk and Contingency Plans
The Company has prepared a contingency plan with trigger dates to pursue
various alternatives should the service bureau fail to adequately modify and/or
provide sufficient testing and validation resources for the Company and the
service bureau to ensure the mission critical applications are Year 2000
compliant.
The principal risks associated with the Year 2000 problem relate to the
Company preparing its operations for the next century and the risk that the
Company's operations will be disrupted due to operational failures of third
parties. With respect to the Company's own preparedness, the Company, like
other financial institutions, is heavily dependent on its computer systems,
which are heavily dependent on the services of the Company's service provider.
The complexity of these systems and their dependence on one another makes it
impossible to switch to other systems almost immediately as would be necessary
if necessary corrections were not made in advance. Management believes that it
will be able to make the necessary corrections in advance. The most likely
worst case scenario is that the testing and validation of the software
modifications will not be completed by the scheduled deadline of July 1999.
This worst case scenario could increase the Company's overall expected Year
2000 costs; however, management believes that this scenario is not probable to
occur and if the scenario should occur, that the impact of these additional
costs would not be material to the Company's financial position and results of
operations.
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS OF FORM 8-K
a. See EXHIBIT 27-Financial Data Schedule.
b. On October 8, 1998, the Registrant filed a report on Form 8-K
announcing the definitive Agreement and Plan of Merger between the
Registrant and Washington Independent Bancshares, Inc. The Agreement
and Plan of Merger was filed with the Form 8-K.
c. On October 29, 1998, the Registrant filed a report on Form 8-K
announcing the change in the Company's year end from June 30 to
December 31.
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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
Date: November 5, 1998 by /s/ DONALD V. RHODES
---------------------------------
Donald V. Rhodes
Chairman, President and Chief Executive Officer
(Duly Authorized Officer)
by /s/ JAMES HASTINGS
---------------------------------
James Hastings
Vice President and Treasurer
(Principal Financial and Accounting Officer)
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