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 March 31, 1999
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 May 6, 1999 there were outstanding 10,901,123 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 March 31, 1998 and 1999
Consolidated Statements of Financial Condition 4
As of December 31, 1998 and March 31, 1999
Consolidated Statements of Stockholders' Equity and 5
Comprehensive Income for the Three Months Ended
March 31, 1999
Consolidated Statements of Cash Flows for the 6
Three Months Ended March 31, 1998 and 1999
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 15
PART II. Other Information
Item 6. Exhibits and Reports on Form 8-K 17
Signatures 18
Page 2
HERITAGE FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except for per share data)
(unaudited)
Three Months
Ended
March 31,
---------------------
1998 1999
------ -----
INTEREST INCOME:
Loans $5,927 7,492
Investment securities and FHLB dividends 404 756
Interest bearing deposits 982 460
------ -----
Total interest income 7,312 8,708
INTEREST EXPENSE:
Deposits 2,942 3,238
Borrowed funds 11 11
------ -----
Total interest expense 2,953 3,249
------ -----
Net interest income 4,359 5,459
PROVISION FOR LOAN LOSSES 39 102
------ -----
Net interest income after provision for loan loss 4,320 5,357
NONINTEREST INCOME:
Gains on sales of loans 716 432
Commissions on sales of annuities
and securities 32 82
Service charges on deposits 243 334
Rental income 52 49
Other income 125 191
------ -----
Total noninterest income 1,168 1,088
NONINTEREST EXPENSE:
Salaries and employee benefits 1,867 2,497
Building occupancy 544 765
Data processing 220 273
Marketing 106 136
Goodwill Amortization 3 144
Other 750 887
------ -----
Total noninterest expense 3,490 4,702
------ -----
Income before federal income tax 1,998 1,743
Federal income tax 686 636
------ -----
Net income $1,312 1,107
====== =====
Earnings per share :
Basic $0.13 0.10
Diluted $0.12 0.10
See Notes to Condensed Consolidated Financial Statements
Page 3
HERITAGE FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands)
December 31, March 31,
1998 1999
---------------------------------
Assets (Unaudited)
Cash on hand and in banks $ 13,793 12,702
Interest earning deposits 36,355 19,406
Federal funds sold 20,800 15,500
Investment securities available for sale 31,625 38,000
Investment securities held to maturity 15,897 11,217
Loans held for sale 7,618 3,131
Loans receivable 319,334 327,570
Less: Allowance for loan losses (3,957) (4,086)
---------------------------------
Loans, net 315,377 323,484
Real Estate Owned - 70
Premises and equipment, net 18,122 18,501
Federal Home Loan Bank stock 2,136 2,176
Accrued interest receivable 2,735 3,042
Prepaid expenses and other assets 3,041 1,884
Goodwill 8,372 8,228
---------------------------------
$475,871 457,141
=================================
Liabilities and Stockholders' Equity
Deposits 367,104 348,404
Advances from Federal Home Loan Bank 688 682
Other borrowings 17 15
Advance payments by borrowers for taxes and insurance 476 641
Accrued expenses and other liabilities 5,992 5,163
Deferred Federal income taxes 1,035 1,137
---------------------------------
375,312 356,042
Stockholders' equity:
Common stock, no par value per share,15,000,000 shares authorized;
10,844,916 shares and 10,857,794 outstanding, respectively 77,476 77,522
Unearned compensation ESOP and Other (1,242) (1,230)
Retained earnings, substantially restricted 24,199 24,709
Accumulated other comprehensive income 126 98
---------------------------------
Total stockholders' equity 100,559 101,099
Commitments and contingencies
---------------------------------
$475,871 457,141
=================================
See Notes to Condensed Consolidated Financial Statements
Page 4
HERITAGE FINANCIAL CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
For the Three Months Ended March 31, 1998 and 1999
(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 Dec 31, 1998 10,845 $77,476 (1,242) 24,199 126 100,559
Earned ESOP shares - - 12 - - 12
Exercise of stock options 13 46 - - - 46
Net income - - - 1,107 - 1,107
Unrealized loss on securities
available for sale, net of tax - - - - (28) (28)
Cash dividend declared - - - (597) - (597)
---------------------------------------------------------------------------------------------
Balance at March 31, 1999 10,858 $77,522 (1,230) 24,709 98 101,099
=============================================================================================
Three months ended
Comprehensive Income March 31,
--------------------------------------------
1998 1999
--------------------------------------------
Net income $1,312 $1,107
Unrealized loss on securities
available for sale, net of tax - (28)
--------------------------------------------
Comprehensive income $1,312 $1,079
============================================
See Notes to Condensed Consolidated Financial Statements
Page 5
HERITAGE FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)
Three Months
Ended
March 31,
---------------------
1998 1999
-------- -------
Cash flows from operating activities:
Net income $ 1,312 1,107
Adjustments to reconcile net income to net cash provided (used) by
operating activities
Amortization of goodwill - 144
Depreciation and amortization 255 402
Deferred loan fees, net of amortization (86) 20
Provision for loan losses 39 102
Net (increase)decrease in loans held for sale (3,108) 4,486
Federal Home Loan Bank stock dividends (31) (40)
Recognition of compensation related to ESOP - 12
Net change in accrued interest receivable, prepaid expenses and
other assets, and accrued expenses and other liabilities 646 144
---------------------
Net cash provided(used) by operating activities (973) 6,377
---------------------
Cash flows from investing activities:
Loans originated, net of principal payments and loan sales (3,403) (8,150)
Proceeds from maturities of investment securities available for sale 1,885 3,498
Proceeds from maturities of investment securities held to maturity 3,374 4,680
Purchase of investment securities available for sale (4,375) (9,711)
Purchase of investment securities held to maturity (13,459) -
Purchase of premises and equipment (49) (1,047)
---------------------
Net cash provided(used) by investing activities (16,027) (10,730)
---------------------
Cash flows from financing activities:
Net decrease in deposits (70,129) (18,700)
Net decrease in borrowed funds (39) (8)
Net increase in advance payment by borrowers for taxes
and insurance 278 165
Cash dividends paid - (490)
Proceeds from exercise of stock options 25 46
Net proceeds from stock offering 63,030 -
---------------------
Net cash used by financing activities (6,835) (18,987)
---------------------
Net decrease in cash and cash equivalents (23,835) (23,340)
Cash and cash equivalents at beginning of period 98,686 70,948
---------------------
Cash and cash equivalents at end of period $ 74,851 47,608
=====================
Supplemental disclosures of cash flow information:
Cash payments for:
Interest expense $ 2,925 3,227
Federal income taxes 776 190
See Notes to Condensed Consolidated Financial Statements
Page 6
HERITAGE FINANCIAL CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three Months Ended March 31, 1998 and 1999
(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 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 December 31, 1998 audited consolidated financial
statements and notes thereto included in the Company's Annual Report on Form
10-K/A 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 March 31, 1999 are not necessarily indicative of the results
that may be expected for the year ended December 31, 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, the disclosure of contingent
assets and liabilities and the amount of revenues and expenses for the periods
presented.
Page 7
NOTE 2. BUSINESS COMBINATIONS
(a.) North Pacific Bank
The Company completed the acquisition of North Pacific Bank effective June 12,
1998. Effective November 20, 1998, the operations of North Pacific Bank were
merged with Heritage Bank. This acquisition was treated as a purchase for
accounting purposes. The financial statements for the three months ended March
31, 1999 include the operations of the former North Pacific Bank. The following
information presents the proforma results of operations for the three months
ended March 31, 1998 as though the acquisition had occurred on January 1, 1998.
The proforma results do not necessarily indicate the actual result that would
have been obtained.
Three Months Ended
March 31, 1998
Unaudited Proforma
------------------
(in thousands except
per share amounts)
Net interest income before
provision for loan losses $5,913
Net income 1,479
Earnings per share:
Basic $0.14
Diluted $0.13
(b.) Washington Independent Bancshares, Inc.
Effective March 5, 1999, the Company acquired all of the outstanding common
stock of Washington Independent Bancshares, Inc. (whose wholly owned subsidiary
is Central Valley Bank, N.A., Toppenish, Washington) in exchange for 1,058,200
shares of Heritage common stock. This transaction was accounted for as a
pooling of interests and, accordingly, the Company's financial information
reported herein has been restated to include the accounts and results of
operations of Washington Independent Bancshares, Inc.
NOTE 3. STOCKHOLDERS' EQUITY
(a.) Earnings per Share
The following table reconciles the weighted average shares used for earnings
per share for the applicable periods.
Three months ended
March 31,
1998 1999
-----------------------------
Basic:
Weighted average shares outstanding 10,533,600 10,852,620
-----------------------------
Diluted:
Basic weighted average share outstanding 10,533,600 10,852,620
Incremental shares from stock options 544,745 248,163
-----------------------------
Weighted average shares outstanding 11,078,345 11,100,782
=============================
At March 31, 1999, there were options to purchase 92,700 shares of common stock
outstanding which were antidilutive and therefore not included in the
computation of diluted earnings per share. There were no antidilutive
outstanding options to purchase common stock at March 31, 1998.
(b.) Cash Dividend Declared
On March 25, 1999, the Company announced a quarterly cash dividend of 5.5 cents
per share payable on April 26, 1999 to shareholders of record on April 15, 1999.
NOTE 4. SUBSEQUENT EVENT
On April 29, 1999, the Company announced its intention to repurchase up to
100,000 shares of its outstanding common stock. On May 6, 1999, the Company
announced the completion of its open market share repurchase of 100,000 shares.
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 December 31, 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 March 31, 1999 declined to $457.1
million and $348.4 million, respectively, from December 31, 1998 levels of
$475.9 million and $367.1 million, respectively. During the three months ended
March 31, 1999, total assets and deposits declined 4% and 5%, respectively,
primarily due to management's realignment of its pricing on certificates of
deposit to partially offset the impact of falling earning asset yields on its
net interest income. During the three months ended March 31, 1999, net loans
increased $3.6 million, or 1%, to $326.6 million from December 31, 1998.
Commercial loans increased to $135.5 million at March 31, 1999, compared with
$128.2 million at December 31, 1998, an increase of 6%. At March 31, 1999
commercial loans as a percentage of total loans increased to 41% compared with
23% and 39% at March 31, 1998 and December 31, 1998, respectively.
Page 9
Earnings Summary
Net income for the three months ended March 31, 1999 was $1.1 million, or $0.10
per diluted share, compared to $1.3 million, or $0.12 per diluted share, for the
same period last year, a decrease of 16%. Cash earnings, which exclude the
amortization of goodwill recorded on the acquisition of North Pacific Bank, for
the quarter ended March 31, 1999 were $1.25 million, or $0.11 per diluted share
compared with $0.12 per diluted share for the same quarter last year. The
decrease in net income was attributable to noninterest expenses increasing at a
faster pace than net interest income primarily as a result of the impact of the
acquisition and integration of North Pacific Bank.
Net Interest Income
Net interest income for the three months ended March 31, 1999 increased 25% to
$5.5 million from $4.4 million for the same quarter in 1998. This increase in
net interest income was predominately due to a $66.2 million, or 19%, increase
in the average balance of earning assets for the current quarter versus the same
quarter last year. The acquisition of North Pacific Bank in June 1998 was
responsible for $48.6 million of the total increase in the average balance of
earning assets in the March 1999 quarter.
Net interest margin (net interest income divided by average interest earning
assets) widened to 5.26% for the current quarter from 5.00% for the same
quarter last year. The increase in net interest margin reflects the impact of
the acquisition of North Pacific Bank as North Pacific Bank had a higher net
interest margin than Heritage Bank. 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. The average yield on
earning assets remained at 8.39% for the current quarter and the March 1998
quarter due to the average balance of loans growing faster (30%) than average
earning assets (19%) and thereby shifting lower yielding funds in interest
earning deposits into higher yielding loans in the face of declining loan
yields. This decline in loan yields resulted from lower market interest rates
triggered by Federal Reserve rate reductions in the fourth quarter of 1998. The
Company's cost of funds declined to 3.81% for the current quarter from 4.57% for
the March 1998 quarter due to an increase in lower costing deposits, primarily
savings, interest bearing demand and money market accounts and a decline in
market interest rates. The structural shift in deposit mix is part of the
Company's strategy to transform its balance sheet toward an emphasis on
commercial banking relationships and in particular, to reduce its dependency on
certificates of deposit. The acquisitions of North Pacific Bank and Central
Valley Bank have enhanced the Company's commercial banking focus.
Provision for Loan Losses
The Company increased the provision for loan losses to $102,000 for the current
quarter from $39,000 for the March 1998 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 decreased 7% to $1.1 million for the three months ended March
31, 1999, compared with the same quarter in 1998. This decrease was primarily
attributable to a 30% decrease in the volume of mortgage loans sold due to lower
mortgage loan originations during first quarter 1999 compared with the first
quarter 1998. This decrease in loan sale gains was partially offset by a 38%
increase in service charges on deposits in first quarter 1999 due to a
comparable increase in average deposit balances which resulted primarily from
the acquisition of North Pacific Bank.
Noninterest Expense
Noninterest expense increased 35% to $4.7 million for the first quarter 1999,
compared to $3.5 million for first quarter 1998. Of this total increase, $0.7
million was due to the impact of the acquisition and integration of the
operations of North Pacific Bank, primarily in the areas of compensation,
occupancy, amortization of goodwill and other noninterest expenses. The
efficiency ratio for the quarter ended March 31, 1999 increased to 71.83% from
63.13% for the comparable quarter in 1998. Contributing to this increase,
revenues were below expected levels due to a 40% drop in gains on sale of
mortgage loans (compared with the 1998 quarter) and a decrease in the yield on
earning assets which resulted from falling market interest rates initiated by
Federal Reserve rate cuts in fourth quarter 1998. In addition, noninterest
expenses included the aforementioned $0.7 million impact of the North Pacific
Bank acquisition (which included $144,000 in goodwill amortization).
Page 11
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 $330.7 million
at March 31, 1999 from $326.9 million at December 31, 1998. At March 31, 1999,
commercial loans increased to $135.5 million, or 40.97% of total loans, from
$128.2 million, or 39.20% of total loans, at December 31, 1998.
(in thousands)
At At
December 31, % of March 31, % of
1998 Total 1999 Total
-------------------------------------------------------------
Commercial $128,171 39.20 % $135,496 40.97 %
Real estate mortgages
One-to-four family residential 97,277 29.76 91,187 27.58
Five or more family and commercial
properties 70,139 21.45 70,784 21.40
-------------------------------------------------------------
Total real estate mortgages 167,416 51.21 161,971 48.98
Real estate construction
One-to-four family residential 26,640 8.15 28,225 8.54
Five or more family and commercial
properties 2,124 0.65 2,686 0.81
-------------------------------------------------------------
Total real estate construction 28,764 8.80 30,911 9.35
Consumer 4,000 1.22 3,703 1.12
-------------------------------------------------------------
Gross loans 328,351 100.43 % 332,081 100.42 %
Less: deferred loan fees (1,399) (0.43) (1,380) (0.42)
Total loans $326,952 100.00 % $330,701 100.00 %
=============================================================
Page 12
Nonperforming Assets
The following table sets forth the amount of the Bank's nonperforming assets at
the dates indicated.
At At
December 31, March 31,
1998 1999
============================
(Dollars in thousands)
Nonaccrual loans $ 402 235
Restructured loans - -
----------------------------
Total nonperforming loans 402 235
Real estate owned - 70
----------------------------
Total nonperforming assets $ 402 305
============================
Accruing loans past due 90 days or more $ 8 -
Potential problem loans 898 1,990
Allowance for loan losses 3,957 4,086
Nonperforming loans to loans 0.12% 0.07%
Allowance for loan losses to loans 1.21% 1.24%
Allowance for loan losses to nonperforming loans 984.70% 1740.40%
Nonperforming assets to total assets 0.08% 0.07%
Nonperforming loans decreased to $235,000, or 0.07% of total loans, at March 31,
1999 from $402,000, or 0.12% of total loans, at December 31, 1998.
Nonperforming assets at March 31, 1999 amounted to $305,000, or 0.07% of total
assets.
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 13
The following table sets forth for the periods indicated information regarding
changes in the Company's allowance for loan losses:
Three Months Ended March 31,
----------------------------------
1998 1999
----------------------------------
Total loans outstanding at end of period (1) $257,019 330,701
Average loans outstanding during period 253,311 329,088
Allowance balance at beginning of period 3,180 3,957
Provision for loan losses 39 102
Charge-offs
Real estate - -
Commercial - -
Consumer - (3)
----------------------------------
Total charge-offs - (3)
----------------------------------
Recoveries
Real estate - -
Commercial - 30
Consumer 1 -
----------------------------------
Total recoveries 1 30
----------------------------------
Net (charge-offs) recoveries 1 27
----------------------------------
Allowance balance at end of period $ 3,220 4,086
==================================
Ratio of net (charge-offs) recoveries during
period to average loans outstanding 0.000% (0.008%)
==================================
_____________
(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 March 31, 1999 increased $129,000 to
$4.1 million, or 1.24% of total loans. This ratio of allowance for loan losses
to total loans has increased to 1.24% at March 31, 1999 from 1.21% at December
31, 1998 due to the $102,000 provision and $27,000 in net recoveries during the
quarter while total loans increased at a slower pace.
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 March 31, 1999, cash and cash equivalents
totaled $47.6 million, or
Page 14
10% of total assets, and investment securities classified as either available
for sale or held to maturity with maturities of one year or less amounted to
$5.6 million, or 1.2% of total assets. At March 31, 1999, the Company maintained
a credit facility with the FHLB of Seattle for up to 20% of assets or $77.0
million (of which only $682,000 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 March 31, 1999 was $101.1 million compared with $100.6
million at December 31, 1998. In addition to the Company's earnings, proceeds
from the exercise of stock options totaling $46,000 increased stockholders'
equity during the quarter. During the three months ended March 31, 1999, the
Company declared a cash dividend in the amount of $597,000, or 5.5 cents per
share, to shareholders of record on April 15, 1999.
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 March 31, 1999, the Company's leverage ratio was
20.0%, compared with 21.5% at December 31, 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 28.5% and 29.8%, respectively, at March 31,
1999 compared with 27.9% and 29.1%, respectively, at December 31, 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 Central Valley Bank
qualified as "well-capitalized" at March 31, 1999.
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 15
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 December
31, 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) and Central Valley Bank (CVB) utilize service
bureaus to perform each bank's most mission critical data processing services
related to its loans, deposits, general ledger and other financial applications.
Both banks' service bureaus have informed them that the service bureau has
completed the software programming for 100% of its applications. For HB, testing
of these service bureau programs commenced in October 1998 and testing and
implementation are expected to be completed by mid-1999. For CVB, testing and
implementation of those service bureau programs was completed in the fourth
quarter 1998. 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 Heritage Bank's costs related to Year 2000 issues to amount
to approximately $230,000. Of this total, approximately $174,000 was incurred in
prior periods. Management expects the remainder of these costs ($56,000) to be
incurred in 1999. Central Valley
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Bank will be upgrading computer equipment and related software for the remaining
two of its five branches in 1999 at an approximate cost of $60,000. Total costs
for the Company's Year 2000 efforts in 1999 are expected to be approximately
$125,000.
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 required 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 January 26, 1999, the Registrant filed a report on Form 8-K
announcing the financial results of the Registrant for the interim
period ended December 31, 1998.
c. On March 10, 1999, the Registrant filed a report on Form 8-K announcing
the completion of the merger (effective March 5, 1999) of the
Registrant and Washington Independent Bancshares, Inc., Toppenish,
Washington.
d. On April 29, 1999, the Registrant filed a report on Form 8-K announcing
that its Board of Directors had authorized the purchase of up to
100,000 of its outstanding shares.
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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: May 12,1999 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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