Heritage Financial Announces Second Quarter 2020 Results And Declares Regular Cash Dividend

OLYMPIA, Wash., July 23, 2020 /PRNewswire/ -- Heritage Financial Corporation (NASDAQ GS: HFWA) (the "Company" or "Heritage"), the parent company of Heritage Bank ("Bank"), today reported that the Company had a net loss of $6.1 million for the quarter ended June 30, 2020 compared to net income of $12.2 million for the linked-quarter ended March 31, 2020 and net income of $16.0 million for the quarter ended June 30, 2019. The losses per share for the quarter ended June 30, 2020 was $0.17 compared to earnings per share of $0.33 for the linked-quarter ended March 31, 2020 and $0.43 for the quarter ended June 30, 2019. Financial results for the quarter ended June 30, 2020 included a provision for credit losses of $28.6 million primarily as a result of additional estimated credit losses forecasted due to the Coronavirus ("COVID-19") pandemic and its impact on the economy.

Jeffrey J. Deuel, President and Chief Executive Officer of Heritage commented, "We are pleased with our progress in the second quarter, particularly our contribution to the origination of SBA PPP loans for our customers and communities. The overlay of COVID-19 has been challenging and, while there is still a lot of uncertainty, we believe we are prepared to manage through this unprecedented time.

We are also pleased with our continuing efforts to make a difference in our local communities. We are proud to have recently been selected as the construction lender and tax credit investor for Yakima Housing Authority's Chuck Austin Place project located in Yakima, Washington. The project includes the rehabilitation of a former U.S. Marine Corps armory building and construction of townhouses providing forty one supportive housing units for homeless veterans."

COVID-19 Response
The Company continues to be committed to supporting its community and its customers during these unprecedented times. This includes offering Small Business Administration's ("SBA") Paycheck Protection Program ("PPP") loans in accordance with the Coronavirus Aid, Relief, and Economic Security Act enacted on March 27, 2020 ("CARES Act"), as amended. As of June 30, 2020, the Bank had funded 4,498 SBA PPP loans totaling $883.9 million with an average loan size of $197,000. The Bank is continuing to accept applications under this program. Of the funded loans, approximately 20% of both the count and the originated balance was issued to new customers as we are also serving those in the Bank's market areas who have not had a banking relationship with the Bank in the past. The Bank is also working with customers to assist them with accessing other borrowing options, including SBA and other government sponsored lending programs, as appropriate. The Bank earns 1.0% interest on these loans as well as a fee from the SBA based on the size of the loan. The fees will be recognized over the duration of the respective loans.

Under the CARES Act and in an attempt to assist its customers and secure loan repayment, the Bank has accommodated loan modifications for its borrowers, including interest only payments for a period of time (generally 90 days), payment deferrals for a period of time (generally 90 days) and other loan modifications. At June 30, 2020, the Bank had 1,821 CARES Act modified loans totaling $591.5 million, of which 839 loans totaling $527.3 million were commercial business loans. Approximately 56% of the commercial business modified loans were interest only payments, 36% were payment deferrals and 8% were other loan modifications. Total CARES Act modified loans are not reported as troubled-debt restructured loans per the enacted guidance.

The Bank believes the steps it is taking are necessary to effectively manage the loan portfolio and to assist customers through the ongoing uncertainty surrounding the duration, impact and government response to the COVID-19 pandemic and continues to monitor opportunities to participate in other regulatory or in-house programs designed to aid in the economic recovery from the COVID-19 pandemic.

Financial Highlights
The following table provides financial highlights at the dates and for the periods indicated:

Investment securities decreased $81.2 million, or 8.4%, to $879.9 million at June 30, 2020 from $961.1 million at March 31, 2020 primarily as a result of maturities, calls and payments of investment securities of $79.9 million and sales of investments of $15.8 million, offset partially by unrealized gains of $9.8 million and investment purchases of $5.3 million during the quarter ended June 30, 2020.

Loans receivable, net increased $790.0 million, or 20.8%, to $4.59 billion at June 30, 2020 from $3.80 billion at March 31, 2020 due primarily to increases in SBA PPP loans of $856.5 million, non-owner occupied commercial real estate ("CRE") loans of $39.5 million and owner-occupied CRE loans of $32.7 million, offset partially by decreases in commercial and industrial loans of $96.5 million and consumer loans of $32.9 million. The decrease in commercial and industrial loans was primarily due to decreases in lines of credit balances. The utilization rate for commercial and industrial lines of credit was 26.2%, 37.5% and 34.5% at June 30, 2020, March 31, 2020, and December 31, 2019, respectively. The decrease in consumer loans was primarily due to the cessation of indirect auto loan originations during the quarter ended June 30, 2020.

The following table summarizes the Company's loan portfolio by type of loan and amortized cost at the dates indicated:

Total deposits increased $949.8 million, or 20.6%, to $5.57 billion at June 30, 2020 from $4.62 billion at March 31, 2020 due primarily to increases in noninterest demand deposits of $584.6 million, or 41.3%, interest bearing demand deposits of $220.0 million, or 16.0%, money market accounts of $103.7 million, or 11.8%, and savings accounts of $76.9 million, or 18.1%, offset partially by a decrease in certificate of deposit accounts of $35.3 million, or 6.7%. The increase in total deposits was due primarily to SBA PPP loan funds deposited into customer accounts. Non-maturity deposits as a percentage of total deposits increased to 91.2% at June 30, 2020 from 88.6% at March 31, 2020.

The following table summarizes the Company's deposits at the dates indicated:

Total stockholders' equity decreased $4.8 million, or 0.6%, to $793.7 million at June 30, 2020 from $798.4 million at March 31, 2020. Changes in stockholders' equity during the periods indicated were as follows:

During the quarter ended June 30, 2020, no shares were repurchased under the Company's stock repurchase plan as the Company halted repurchases in March 2020 (other than the cancellation of stock to pay withholding taxes on vested restricted stock awards or units) in response to the COVID-19 pandemic. As of June 30, 2020, there were 1,643,276 shares available for repurchase under the current stock repurchase plan.

The Company and Heritage Bank continue to maintain capital levels in excess of the applicable regulatory requirements for them to be categorized as "well-capitalized". The following table summarizes capital ratios for the Company at the dates indicated:

Donald J. Hinson, Executive Vice President and Chief Financial Officer, commented, "We continue to maintain strong capital ratios even after a significant addition to our allowance for credit losses in the second quarter. This capital position has enabled us to sustain our quarterly dividends at prior-quarter levels. As we progress through this economic downturn, we will monitor and manage our projected capital levels in order to preserve our strong capital position."

Allowance for Credit Losses

Effective January 1, 2020, the Company adopted the Financial Accounting Standard Board's Accounting Standards Update 2016-13: Financial Instruments: Credit Losses (Topic 326), as amended, and commonly referred to as CECL, under the modified retrospective method; therefore, periods prior to the effective date are not comparable.

During the quarter ended June 30, 2020, the allowance for credit losses ("ACL") on loans increased $24.0 million, or 50.4%, to $71.5 million at June 30, 2020. The increase was due primarily to a provision for credit losses on loans of $25.9 million which reflects additional estimated credit losses as the forecasted impacts of the COVID-19 pandemic worsened since the linked-quarter end. The macroeconomic forecast for the quarter ended June 30, 2020 included a widened "U-shaped" recovery with unemployment rate spiking to 13% in second quarter 2020 and decreasing to 5% by 2023, and Gross Domestic Product ("GDP") slumping 6.1% in 2020, but rebounding 6.3% in 2021, with modest increases in GDP in future years. The macroeconomic factors for the linked-quarter ended March 31, 2020 utilized a "V-shaped" recovery assumption with unemployment rates rising to 6% in second quarter 2020 and quickly falling, and GDP contracting 0.2% in 2020. Additionally, the ACL on loans at March 31, 2020 included changes in qualitative factors related to the industries in the loan portfolio that the Company believed may suffer the most losses as a result of the COVID-19 pandemic, such as restaurants, hotels, not-for-profit organizations and recreational and entertainment centers, as the macroeconomic model was as of March 20, 2020 and, therefore, did not entirely include the economic developments as of March 31, 2020.

The Bank recognized net charge-offs of $2.0 million during the quarter ended June 30, 2020 due primarily to a charge-off of a commercial and industrial loan of $1.7 million that had been experiencing financial difficulties. Due to issues surrounding the control of the underlying loan collateral, the Bank determined it appropriate to charge-off the entire balance and pursue an aggressive collection strategy. Net charge-offs were $417,000 for the linked-quarter ended March 31, 2020 and $1.2 million for the same quarter in 2019.

The Company believes that its ACL on loans is appropriate to provide for current expected credit losses in the loan portfolio at June 30, 2020.

During the quarter ended June 30, 2020, the ACL on unfunded commitments increased $2.6 million, or 131.7%, to $4.6 million at June 30, 2020. The increase was due primarily to the combination of an increase in estimated loss rates and a decrease in the utilization rate on revolving commercial and industrial lines of credit. Loss rates on unfunded commitments are the same as those developed for the ACL on loans and likewise reflects the worsening economic conditions related to the COVID-19 pandemic.

The following table provides detail on the changes in the ACL on loans and unfunded commitments and the related provision for credit losses for the periods indicated:

Credit Quality
Nonperforming assets decreased to 0.51% of total assets at June 30, 2020 compared to 0.63% of total assets at March 31, 2020. The decrease was due primarily to an increase in total assets due to originations of SBA PPP loans. Nonperforming assets at June 30, 2020 include only nonaccrual loans due to the sale of the one remaining other real estate owned ("OREO") property during the quarter ended June 30, 2020.

Changes in nonaccrual loans during the periods indicated were as follows:

The ACL on loans to nonaccrual loans increased to 212.62% at June 30, 2020 compared to 139.16% at March 31, 2020 due primarily to the increase in the ACL, as discussed above.

Potential problem loans decreased $1.6 million, or 1.6%, to $100.6 million at June 30, 2020 compared to $102.2 million at March 31, 2020. The decrease was primarily attributed to net principal payments and upgrades to pass status, including the upgrade of one commercial and industrial loan of $5.7 million which demonstrated improved and sustained financial strength throughout one year of monitoring. The decrease in potential problem loans was offset partially by the addition of two owner-occupied CRE relationships and one commercial and industrial relationship totaling $8.4 million that experienced cash flow deterioration as a result of customer-specific events. In addition, one owner-occupied CRE relationship and one commercial and industrial relationship totaling $2.5 million were downgraded as a result of impacts from the COVID-19 pandemic. The Bank's practice on COVID-19 related loan issues was to downgrade to a "Watch" grade if the loan was modified, unless the borrower showed strong financials or other factors indicated a more severe grade was necessary.

Changes in potential problem loans during the periods indicated were as follows:

Operating Results
Net interest income increased $1.8 million, or 3.6%, to $50.3 million for the quarter ended June 30, 2020 from $48.6 million for the linked-quarter ended March 31, 2020 due primarily to an increase in the interest earning assets during the quarter ended June 30, 2020 and a decrease in the cost of total interest bearing liabilities, offset partially by decreases in yields on adjustable rate instruments following significant decreases in the federal funds target rate by the Federal Reserve in response to the COVID-19 pandemic. Net interest income decreased $223,000, or 0.4%, from $50.5 million for the same period in 2019 due primarily to decreases in yields on adjustable rate instruments following sustained decreases in short-term market rates, partially offset by increases in interest earning assets and decreases in the cost of interest bearing liabilities.

The federal funds target rate history since December 31, 2018 is as follows:

Net interest margin decreased 42 basis points to 3.64% for the quarter ended June 30, 2020 from 4.06% for the linked-quarter ended March 31, 2020 due primarily to changes in the mix of interest earning assets and decreases in the yield of interest earning assets, offset partially by decreases in the cost of interest bearing liabilities. Average interest earning assets increased $740.7 million, or 15.4%, from the linked-quarter due primarily to the origination of SBA PPP loans with an average balance of $667.4 million during the quarter ended June 30, 2020 and secondarily due to an increase in average interest earning deposits of $60.0 million, or 47.9%, during the quarter ended June 30, 2020. The yield on SBA PPP loans was 2.97%, including the recognition of the net deferred fees, during the quarter ended June 30, 2020, and the yield on interest earning deposits was 0.09% during the quarter ended June 30, 2020 compared to 1.35% during the linked-quarter ended March 31, 2020. The decrease in the other components of the loan yield is described below. The cost of interest bearing liabilities decreased 14 basis points to 0.40% during the quarter ended June 30, 2020 from 0.54% during the linked-quarter ended March 31, 2020 due primarily to the decrease in market rates.

Net interest margin decreased 0.69% from 4.33% for the quarter ended June 30, 2019 due to similar reasons as the linked-quarter decrease, including the origination of SBA PPP loans; increases in interest earning deposits of $137.8 million, or 289.6% combined with a significant decline in the yield to 0.09% during the quarter ended June 30, 2020 from 2.39% for the same period in 2019; and decreases in yields on adjustable instruments due to market interest rates.

Loan yield decreased 59 basis points to 4.38% for the quarter ended June 30, 2020 from 4.97% for the linked-quarter ended March 31, 2020 primarily as a result of a full quarter impact of the decrease in short-term market rates. Approximately 56% of the loan portfolio at March 31, 2020 was comprised of adjustable loans and 23% of those adjustable rate loans repriced within the quarter. Loan yield also decreased as a result of funding SBA PPP loans during the quarter ended June 30, 2020 at a yield of 2.97%, resulting in a negative impact to the loan yield of 24 basis points. Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans was 4.56% for the quarter ended June 30, 2020 compared to 4.86% for the linked for the linked-quarter ended March 31, 2020. Loan yield decreased 90 basis points from 5.28% for the quarter ended June 30, 2019 due primarily to sustained decreases in short-term market rates and secondarily due to the impact of the lower yielding SBA PPP loans. Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans was 5.12% for the comparable quarter ended June 30, 2019.

Loan yield is also affected by incremental accretion on purchased loans. The impact of incremental accretion on loan yield decreased five basis points to 0.06% during the quarter ended June 30, 2020 from 0.11% for the linked-quarter ended March 31, 2020 and decreased ten basis points from 0.16% for the quarter ended June 30, 2019. The impact of incremental accretion on loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the purchased loans decreases.

The following table presents the loan yield and the impacts of the balances and interest and fees earned on SBA PPP loans and the incremental accretion on purchased loans on this financial measure for the periods presented below:

The yield on the aggregate investment portfolio decreased 33 basis points to 2.41% for the quarter ended June 30, 2020 from 2.74% for the linked-quarter ended March 31, 2020 and decreased 39 basis points from 2.80% for the quarter ended June 30, 2019 due primarily to decreases in market interest rates impacting adjustable rate securities, offset partially by recognition of discounts related to increases in prepayments of investment securities due to the low interest environment.

The cost of total deposits decreased 11 basis points to 0.26% during the quarter ended June 30, 2020 from 0.37% for both the linked-quarter ended March 31, 2020 and the quarter ended June 30, 2019 due primarily to decreases in market interest rates following decreases in the federal funds target rate mentioned previously, offset partially by a significant increase in the average balance of noninterest demand deposits.

Provision for credit losses of $28.6 million was recorded during the quarter ended June 30, 2020, which is comprised of the estimated losses for loans and unfunded commitments.

The provision for credit losses on loans increased $15.9 million, or 160.3%, to $25.9 million during the quarter ended June 30, 2020 compared to $10.0 million during the quarter ended March 31, 2020 due to the worsening of forecasted conditions as explained in the Allowance for Credit Losses section above. The amount of provision for credit losses on loans recorded during the quarter ended June 30, 2020 was necessary to increase the ACL on loans to an amount that management determined to be appropriate and estimated the credit losses on loans at June 30, 2020 based on its adopted CECL methodology. The provision for loan losses for the same period in 2019 was estimated under the previously utilized incurred loss methodology.

The Company recorded a provision for credit losses on unfunded commitments of $2.6 million during the quarter ended June 30, 2020 compared to a reversal of provision for credit losses on unfunded commitments of $2.0 million during the quarter ended March 31, 2020 primarily as a result of an increase in estimated loss rates and a decrease in the utilization rates of revolving commercial and industrial lines of credit as previously mentioned. The Company did not record a provision for credit losses on unfunded commitments during the same period in 2019 under the incurred loss methodology.

Noninterest income decreased $1.2 million, or 13.1%, to $8.2 million for the quarter ended June 30, 2020 from $9.5 million for the linked-quarter ended March 31, 2020 due primarily to a decrease in service charges and other fees of $776,000, or 17.7%, which included a decrease in overdraft fees of $593,000, and a decrease in other income of $918,000, or 28.2%, which included a decrease in Merchant Visa fees of $311,000 as a result of changes in customer spending habits during the COVID-19 pandemic. The decrease in other income also related to a bank-owned life insurance death benefit payout recorded during the quarter ended March 31, 2020. The decrease in noninterest income was additionally due to a decrease of $605,000 in gain on sale of investment securities, net. These decreases in noninterest income were offset partially by increases in gain on sale of mortgage loans of $588,000, or 107.5%, as a result of increased residential refinance activity during this period of low market interest rates.

Noninterest income increased $684,000, or 9.0%, from $7.6 million for the same period in 2019 due primarily to an increase in gain on sale of loans of $767,000, or 208.4%, as a result of the volume increase due to the lower interest rate environment and an increase in interest rate swap fees of $608,000, or 377.6%, based on customer transactions. These increases in noninterest income were offset partially by a decrease in service charges and other fees of $1.2 million, or 25.7%, primarily related to decreases in overdraft fees and interchange fees related to changes in customer spending habits due to the COVID-19 pandemic.

Noninterest expense decreased $187,000, or 0.5%, to $37.1 million for the quarter ended June 30, 2020 from $37.3 million for the linked-quarter ended March 31, 2020 due primarily to a decrease in compensation and employee benefits of $579,000, or 2.6%, substantially due to the deferral of compensation related to origination costs of SBA PPP loans, partially offset by an increase in sales commission expense related to the mortgage department's increased residential loan production volume. These decreases in noninterest expense were offset partially by an increase in professional services of $792,000, or 57.5%, related primarily to the launch of the new mobile and online commercial banking platform, "Heritage Direct," and an increase in federal deposit insurance premium expense of $238,000 due to the Bank utilizing the remaining balance of its small bank credit awarded by the FDIC and resuming the accrual for this expense in the current quarter. The implementation of Heritage Direct was completed during the quarter ended June 30, 2020.

Noninterest expense decreased $474,000, or 1.3%, compared to $37.5 million for the quarter ended June 30, 2019 due to a reduction of employee lodging, meal and travel expenses related to the Company's suspension of non-essential travel due to COVID-19 (included in "other expense" category); a decrease in other real estate owned, net as a result of a gain on sale recognized during the quarter ended June 30, 2020 compared to a loss on sale recognized during the quarter ended June 30, 2019; a decrease in marketing expense related to the delayed timing of contributions for community sponsorships and  sponsored events due to COVID-19 restrictions; and a decrease in federal deposit insurance premium expense due to the recognition of the remaining small bank credit awarded by the FDIC during the quarter ended June 30, 2020 compared to no credit recognized during the quarter ended June 30, 2019. These decreases in noninterest expense were offset partially by an increase in professional services primarily as a result of support and transition expenses related to the Heritage Direct platform previously mentioned.

Income tax benefit was $936,000 for the quarter ended June 30, 2020 compared to income tax expense of $640,000 for the linked-quarter ended March 31, 2020 and income tax expense of $3.2 million for the quarter ended June 30, 2019. The effective tax benefit rate was 13.2% for the quarter ended June 30, 2020 compared to an income tax expense rate of 5.0% for the linked-quarter ended March 31, 2020 and an income tax expense rate of 16.7% for the quarter ended June 30, 2019. The increase in the effective tax rate from the linked-quarter ended March 31, 2020 was primarily due to a provision in the CARES Act, which permitted the Company to recognize a $1.0 million benefit from net operating losses related to prior acquisitions during the quarter ended March 31, 2020. The decrease in the effective tax rate from the quarter ended June 30, 2019 was due to a decrease in pre-tax income which results in an increased impact of favorable permanent tax items such as tax-exempt investments and low-income housing tax credits.

Dividends
On July 22, 2020, the Company's Board of Directors declared a quarterly cash dividend of $0.20 per share, which is unchanged compared to the quarterly dividend paid in the prior quarter. The dividends are payable on August 19, 2020 to shareholders of record as of the close of business on August 5, 2020.

Earnings Conference Call
The Company will hold a telephone conference call to discuss this earnings release on July 23, 2020 at 11:00 a.m. Pacific time. To access the call, please dial (877) 692-8957 -- access code 4585155 a few minutes prior to 11:00 a.m. Pacific time. The call will be available for replay through August 6, 2020 by dialing (866) 207-1041 -- access code 3330931.

About Heritage Financial
Heritage Financial Corporation is an Olympia-based bank holding company with Heritage Bank, a full-service commercial bank, as its sole wholly-owned banking subsidiary. Heritage Bank has a branching network of 62 banking offices in Washington and Oregon. Heritage Bank does business under the Whidbey Island Bank name on Whidbey Island. Heritage's stock is traded on the NASDAQ Global Select Market under the symbol "HFWA". More information about Heritage Financial Corporation can be found on its website at www.hf-wa.com and more information about Heritage Bank can be found on its website at www.heritagebanknw.com.

Non-GAAP Financial Measures
This news release contains certain non-GAAP (Generally Accepted Accounting Principles) financial measures in addition to results presented in accordance with GAAP. Management has presented these non-GAAP financial measures in this earnings release because it believes that they provide useful and comparative information to assess trends in the Company's capital reflected in the current quarter and year-to-date results and facilitate comparison of our performance with the performance of our peers. Where applicable, the Company has also presented comparable earnings information using GAAP financial measures. These non-GAAP measures have inherent limitations, are not required to be uniformly applied and are not audited. They should not be considered in isolation or as a substitute for total stockholders' equity or operating results determined in accordance with GAAP. These non-GAAP measures may not be comparable to similarly titled measures reported by other companies. Reconciliations of the GAAP and non-GAAP financial measures are presented below.

Forward-Looking Statements
This press release includes "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements often include words such as "believe," "expect," "anticipate," "estimate," and "intend" or future or conditional verbs such as "will," "would," "should," "could," or "may." Forward-looking statements are not historical facts but instead represent management's current expectations and forecasts regarding future events, many of which are inherently uncertain and outside of our control. Actual results may differ, possibly materially, from those currently expected or projected in these forward-looking statements. The COVID-19, pandemic is adversely affecting us, our customers, counterparties, employees, and third-party service providers, and the ultimate extent of the impacts on our business, financial position, results of operations, liquidity, and prospects is uncertain. Continued deterioration in general business and economic conditions, including further increases in unemployment rates, or turbulence in domestic or global financial markets could adversely affect our revenues and the values of our assets and liabilities, reduce the availability of funding, lead to a tightening of credit, and further increase stock price volatility. In addition, changes to statutes, regulations, or regulatory policies or practices as a result of, or in response to COVID-19, could affect us in substantial and unpredictable ways. Other factors that could cause or contribute to such differences include, but are not limited to: changes in the interest rate environment; changes in general economic conditions and conditions within the securities markets; legislative and regulatory changes; and other factors described in Heritage's latest Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other documents filed with or furnished to the Securities and Exchange Commission-which are available on our website at www.heritagebanknw.com and on the SEC's website at www.sec.gov. The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, any of the forward-looking statements that we make in this press release or the documents we file with or furnish to the SEC are based only on information then actually known to the Company and upon management's beliefs and assumptions at the time they are made which may turn out to be wrong because of inaccurate assumptions we might make, because of the factors described above or because of other factors that we cannot foresee. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for 2020 and beyond to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company's operating and stock price performance.