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

OLYMPIA, Wash., April 30, 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 net income of $12.2 million for the quarter ended March 31, 2020 compared to $17.1 million for the linked-quarter ended December 31, 2019 and $16.6 million for the quarter ended March 31, 2019. Diluted earnings per share for the quarter ended March 31, 2020 was $0.33 compared to $0.47 for the linked-quarter ended December 31, 2019 and $0.45 for the quarter ended March 31, 2019. Financial results for the quarter ended March 31, 2020 included a provision for credit losses on loans of $10.0 million as a result of adopting CECL and reflects forecasted credit deterioration due to the Coronavirus ("COVID-19") pandemic.

Jeffrey J. Deuel, President and Chief Executive Officer of Heritage commented, "We are pleased with our performance and progress in the first quarter, despite the challenges from COVID-19 and a rapid decrease in interest rates. We believe Heritage is well positioned to navigate these challenges and we will continue to benefit from our core deposit franchise and conservative credit culture, while maintaining our focus on a stable net interest margin and expense management. Further, the robust liquidity and capital position on our balance sheet provides us with a solid foundation to address challenges and take advantage of opportunities."

CARES Act and Paycheck Protection Program (PPP)

In response to the global challenges from the COVID-19 pandemic, the Company is now offering a variety of relief options designed to support our clients and communities, including participating in the U.S. Small Business Administration's ("SBA") Paycheck Protection Program ("PPP") in accordance with the Coronavirus Aid, Relief, and Economic Security Act enacted on March 27, 2020 ("CARES Act"). These SBA loans are designed to help small businesses remain viable and enable them to pay their employees. As of April 26, 2020, the Bank has funded 2,817 PPP loans totaling $687.1 million with an average loan size of $244,000. The Bank earns 1.0% interest on these loans as well as a fee from the SBA based on the size of the loan.

Mr. Deuel added, "We are very pleased to have been able to provide funding to so many small businesses in our local communities. Of the over 2,800 PPP loans we have funded through April 26th, over 50% were for loans under $100,000 and over 80% for loans under $350,000."

Financial Highlights

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

Loans receivable, net increased $73.1 million, or 2.0%, to $3.80 billion at March 31, 2020 from $3.73 billion at December 31, 2019 due primarily to increases in total commercial and industrial loans of $37.5 million, non-owner occupied commercial real estate loans of $23.5 million and real estate construction and land development loans of $12.4 million. The increase in commercial and industrial loans was driven primarily by an increase in funding on existing commercial lines of credit of $29.7 million during the three months ended March 31, 2020. The commercial and industrial loans utilization rate was 40.2% and 35.8% at March 31, 2020 and December 31, 2019, respectively.

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

Total deposits increased $35.3 million, or 0.8%, to $4.62 billion at March 31, 2020 from $4.58 billion at December 31, 2019 due primarily to increases in money market accounts of $124.4 million, or 16.5%, to $878.1 million and in interest bearing demand deposits of $24.3 million, or 1.8%, to $1.37 billion, partially offset by decreases in savings accounts of $83.5 million, or 16.4%, to $425.6 million and in noninterest bearing demand deposits of $31.3 million, or 2.2%, to $1.42 billion. The increase in money market account and the decrease in savings accounts was primarily due to the transfer between deposit accounts of $95.3 million from a large public depositor. Non-maturity deposits as a percentage of total deposits remained constant at 88.6% at both March 31, 2020 and December 31, 2019.

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

Prepaid expenses and other assets increased $16.7 million, or 10.2%, to $180.8 million at March 31, 2020 from $164.1 million at December 31, 2019 primarily as a result of an increase in the fair value of back-to-back interest rate swap contracts of $19.8 million with a corresponding increase in accrued expenses and other liabilities for the same amount.

Total stockholders' equity decreased $10.9 million, or 1.3%, to $798.4 million at March 31, 2020 from $809.3 million at December 31, 2019. Changes in stockholders' equity during the three months ended March 31, 2020 were as follows:

During the quarter ended March 31, 2020, the Company repurchased the remaining 639,922 shares of its common stock available under the previous stock repurchase plan at a weighted average price per share of $23.95, or $15.3 million. The Company commenced a new stock repurchase plan on March 12, 2020, and repurchased 155,778 shares of its common stock under that plan at a weighted average price per share of $20.34, or $3.2 million during the quarter ended March 31, 2020. As of March 31, 2020, there were 1.6 million shares available for repurchase under the new stock repurchase plan. The new stock repurchase plan was suspended on March 18, 2020 and will be monitored with the opportunity to reinstitute when the Company deems it appropriate.

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 a strong capital position which has allowed us to maintain our dividend this quarter in spite of an uncertain economic environment. Although we were active in stock buybacks in the first quarter, we halted our buybacks in March and will not resume buybacks until we are confident we can fully understand the impact of COVID-19 pandemic on our long-term capital position."

Allowance for Credit Losses on Loans

Effective January 1, 2020, the Bank 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 the Current Expected Credit Loss model ("CECL"), under the modified retrospective method. The adoption replaced the allowance for loan losses with the allowance for credit losses ("ACL") on loans on the Condensed Consolidated Statements of Financial Condition and replaced the related provision for loan losses with the provision for credit losses on loans on the Condensed Consolidated Statements of Income. Upon adoption, the Bank recorded an increase in the beginning ACL on loans of $1.8 million, increasing the ACL on loans as a percentage of loans receivable to 1.01% as compared to 0.96% at December 31, 2019 prior to adoption. The adoption of CECL also included transition of purchase credit impaired ("PCI") loans to purchase credit deteriorated ("PCD") loans. The Bank elected to account for the PCD loans individually, terminating the pools of loans that were previously accounted for under Accounting Standards Codification 310-30. Upon adoption, an ACL was determined for PCI loans, resulting in an aggregate ACL of $370,000, which was a decrease of $1.9 million from the allowance for loans losses of $2.3 million for these loans at December 31, 2019, as calculated under the prior incurred loss methodology.

The ACL on PCD loans was added to the loans' carrying amount to establish a new PCD amortized cost basis. The difference between the unpaid principal balance and the new amortized cost basis of the PCD loan is the noncredit premium or discount, which will be amortized into interest income over the remaining life of the loan. The PCD transition resulted in a net noncredit discount of $4.3 million, or an increase of $1.5 million in the net purchased discount, from the pre-adoption amount of $2.8 million. The total net purchased discount, including the non-PCI loans, was $9.9 million at January 1, 2020 compared to $8.4 million as of December 31, 2019. The net purchased discount was $9.0 million at March 31, 2020.

Excluding the impacts of the adoption, the ACL on loans increased $9.5 million, or 25.1%, to $47.5 million at March 31, 2020. The increase was due primarily to provision for credit losses on loans of $10.0 million which reflects forecasted credit deterioration due to the COVID-19 pandemic.

The Bank recognized net charge-offs of $417,000 during the quarter ended March 31, 2020. Net charge-offs included commercial and industrial loan charge-offs of $1.1 million, including $373,000 related to one lending relationship, partially offset by the full recovery of an agricultural lending relationship charge-off of $963,000 recorded during the quarter ended December 31, 2019. Net charge-offs were $1.9 million for the linked-quarter ended December 31, 2019 and net recoveries were $190,000 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 March 31, 2020.

Credit Quality

Nonperforming assets decreased to 0.63% of total assets at March 31, 2020 compared to 0.82% of total assets at December 31, 2019. The decrease was due primarily to the payment in full of an agricultural lending relationship of $7.8 million and the payment in full of a commercial business relationship of $2.3 million.

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

The ACL on loans to nonaccrual loans increased to 139.16% at March 31, 2020 compared to an allowance for loan losses to nonaccrual loans of 81.24% at December 31, 2019. The increase was due primarily to the increase in the ACL on loans and the decrease in nonaccrual loans, both as discussed above.

The increase in the ratio of nonperforming assets to total assets was unaffected by other real estate owned as the balance was $841,000 at both March 31, 2020 and December 31, 2019.

Potential problem loans increased $14.4 million, or 16.4%, to $102.2 million at March 31, 2020 compared to $87.8 million at December 31, 2019. The increase was primarily attributed to the addition of four commercial business relationships totaling $18.1 million which were downgraded as a result of impacts from the COVID-19 pandemic and eight commercial business relationships totaling $7.8 million which were downgraded to increase oversight of these credits due to other issues. The activity for the three months ended March 31, 2020 also includes payment in full of three commercial and industrial relationships totaling $4.7 million.

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

We believe we are taking the steps necessary to effectively manage our portfolio through the ongoing uncertainty surrounding the duration, impact and government response to the COVID-19 pandemic. The primary method of relief is to allow the borrower up to 90-day loan payment deferments, although we have also allowed borrowers to pay interest only payments, waived loan late fees, and suspended foreclosure proceedings.

Operating Results

Net interest income decreased $558,000, or 1.1%, to $48.6 million for the quarter ended March 31, 2020 from $49.1 million for the linked-quarter ended December 31, 2019 due primarily to a decrease in the yield of interest earning assets as a result of decreases in interest rates 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 $1.2 million, or 2.5%, compared to $49.8 million for the same period in 2019 due to a decrease in the yield of interest earning assets, primarily as a result of a downward shift in the yield curve and a lagging decrease in the cost of interest bearing deposits.

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

Net interest margin increased four basis points to 4.06% for the quarter ended March 31, 2020 from 4.02% for the linked-quarter ended December 31, 2019 due to primarily to changes in the mix of interest earning assets. Average interest earning assets decreased $37.9 million, or 0.8%, from the linked-quarter due to a decrease in average interest earning deposits of $55.5 million, or 30.7%, which generally earns at a lesser rate than other assets, offset partially by an increase in average loans receivable, net of $29.4 million, or 0.8%. Net interest margin decreased 28 basis points from 4.34% for the quarter ended March 31, 2019 due to decreases in yields of all interest earning assets and an increase in the cost of total interest bearing liabilities.

Loan yield decreased three basis points to 4.97% for the quarter ended March 31, 2020 from 5.00% for the linked-quarter ended December 31, 2019 due primarily to decreases in short-term market rates. The loan yield decrease was offset partially by a change in the mix of the loan portfolio. Average total real estate construction and land development ("construction") loans increased by $25.9 million, or 88.0% of the $29.4 million increase in average loans receivable during the quarter ended March 31, 2020. During the quarter ended March 31, 2020 and the linked-quarter ended December 31, 2019, construction loan yields were 5.77% and 6.20%, respectively. The loan yield decrease as compared to linked-quarter was also partially offset by the favorable impact of the change in nonaccrual loan activity of seven basis points.

Loan yield decreased 26 basis points from 5.23% for the quarter ended March 31, 2019 due primarily to decreases in short-term market rates.

Incremental accretion on purchased loans was impacted by the PCI to PCD transition during the quarter ended March 31, 2020, as explained in the Allowance for Credit Losses section above, which increased the net purchase discount under the modified retrospective method allowed under the CECL adoption. The impact on loan yield from incremental accretion on purchased loans was 11 basis points for both the quarter ended March 31, 2020 and the linked-quarter ended December 31, 2019 and decreased four basis points from 0.15% for the quarter ended March 31, 2019. The incremental accretion and the impact to loan yield will change during any period based on the volume of prepayments, but it is expected to decrease over time as the balance of the purchased loans decreases.

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

The yield on the aggregate investment portfolio increased nine basis points to 2.74% for the quarter ended March 31, 2020 from 2.65% for the linked-quarter ended December 31, 2019 due primarily to an increase in the prepayments of investment securities during the period, including the recognition of related discounts, offset partially by a decrease in market interest rates impacting adjustable rate securities. The yield decreased nine basis points from 2.83% for the quarter ended March 31, 2019 due to decreases in market interest rates impacting adjustable rate securities.

The cost of total deposits decreased two basis points to 0.37% during the quarter ended March 31, 2020 from 0.39% during the linked-quarter ended December 31, 2019 due primarily to a decrease in market interest rates.  Cost of total deposits increased four basis points from 0.33% during the same quarter in 2019 due to competitive pressures and the lag in deposit repricing.

The following table presents the provision for credit losses for the periods presented below:

The Company recorded provision for credit losses on loans of $10.0 million during the quarter ended March 31, 2020 due primarily to forecasted credit deterioration due to the impact of the COVID-19 pandemic. The provision for loan losses for the linked-quarter ended December 31, 2019 and for the same period in 2019 were estimated under the previously utilized incurred loss methodology. The amount of provision for credit losses on loans during the quarter ended March 31, 2020 was necessary to increase the ACL on loans to an amount that management determined to be appropriate at March 31, 2020 based on its adopted CECL methodology.

The Company recorded 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 a decrease in the unfunded commercial construction loan balance resulting from increased funding of the underlying projects during the quarter ended March 31, 2020. The ACL for unfunded commitments was increased $3.7 million on January 1, 2020 as part of the CECL adoption. The Company did not record provision (reversal of provision) for credit losses on unfunded commitments during the linked-quarter ended December 31, 2019 or for the same period in 2019 under the incurred loss methodology.

Noninterest income increased $469,000, or 5.2%, to $9.5 million for the quarter ended March 31, 2020 from $9.0 million for the linked-quarter ended December 31, 2019 due primarily to gain on sale of investment securities, net of $1.0 million as a result of our active management of the portfolio in the current environment. The increase in noninterest income was also due to an increase in other noninterest income due primarily to a bank owned life insurance death benefit payout during the quarter ended March 31, 2020. These increases in noninterest income were offset partially by decreases in interest rate swap fees and gain on sale of loans, net during the quarter ended March 31, 2020 from lower transaction volume. Noninterest income increased $2.1 million, or 27.6%, from $7.4 million for the same period in 2019 due primarily to the increases in gain on sale of investment securities and other noninterest income mentioned previously.

Noninterest expense increased $1.3 million, or 3.5%, to $37.3 million for the quarter ended March 31, 2020 from $36.0 million for the linked-quarter ended December 31, 2019 due primarily to an increase in compensation and employee benefits as a result of higher payroll taxes as annual limitations have not been realized and employee benefits primarily a result of the cost of new medical plans, and an increase in marketing expense due to the timing of contributions to community sponsorships.

Noninterest expense increased $735,000, or 2.0%, compared to $36.5 million for the quarter ended March 31, 2019 due primarily an increase in compensation and employee benefits as a result of an increase in salaries and related payroll taxes, an increase in benefits as previously mentioned, and an increase in stock compensation expense. The increase in noninterest expense was partially offset by a decrease in federal deposit insurance premium expense as a result of a small bank credit awarded by the Federal Deposit Insurance Corporation ("FDIC") recognized during the quarter ended March 31, 2020. The Bank has $139,000 in small bank credits on future assessments remaining as of March 31, 2020, which may be recognized in future periods when allowed for by the FDIC upon insurance fund levels being met.

Income tax expense was $640,000 for the quarter ended March 31, 2020 compared to $3.4 million for the linked-quarter ended December 31, 2019 and $3.2 million for the quarter ended March 31, 2019. The effective tax rate was 5.0% for the quarter ended March 31, 2020 compared to 16.7% for the linked-quarter ended December 31, 2019 and 16.3% for the quarter ended March 31, 2019. The decrease in the effective tax rate from the linked-quarter ended December 31, 2019 and quarter ended March 31, 2019 was due to lower pre-tax income (also reflecting increasing tax-exempt investments) and a provision in 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.

Dividends

On April 29, 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 May 27, 2020 to shareholders of record as of the close of business on May 13, 2020.

Earnings Conference Call

The Company will hold a telephone conference call to discuss this earnings release on April 30, 2020 at 11:00 a.m. Pacific time. To access the call, please dial (877) 692-8955 -- access code 2317360 a few minutes prior to 11:00 a.m. Pacific time. The call will be available for replay through May 14, 2020 by dialing (866) 207-1041 -- access code 3443789.

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. Factors that could cause our actual results to differ materially from those described in the forward-looking statements, include the effect of the COVID-19 pandemic, including on our credit quality and business operations, as well as its impact on general economic and financial market conditions and other uncertainties resulting from the COVID-19 pandemic, such as the extent and duration of the impact on public health, the U.S. and global economies, and consumer and corporate customers, including economic activity, employment levels and market liquidity; 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.