SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE [X] SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2000 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR [_] 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 0-29480 HERITAGE FINANCIAL CORPORATION (Exact name of registrant as specified in its charter) Washington 91-1857900 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 201 Fifth Avenue SW, Olympia, WA 98501 (Address of principal executive office) (ZIP Code) (360) 943-1500 (Registrant's telephone number, including area code) Not Applicable (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ___ ---- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. As of November 1, 2000 there were outstanding 8,495,612 common shares, with no par value, of the registrant. Page 1
HERITAGE FINANCIAL CORPORATION FORM 10-Q INDEX <TABLE> <CAPTION> PART I. Financial Information - ------- --------------------- Item 1. Condensed Consolidated Financial Statements (Unaudited): Page ---- <S> <C> <C> Consolidated Statements of Income for the Three Months and Nine Months Ended September 30, 1999 and 2000 3 Consolidated Statements of Financial Condition As of December 31, 1999 and September 30, 2000 4 Consolidated Statements of Stockholders' Equity for the Nine Months Ended September 30, 2000 and Comprehensive Income for the Three and Nine Months Ended September 30, 1999 and 2000 5 Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 1999 and 2000 6 Notes to Condensed Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk 15 PART II. Other Information Item 6. Exhibits and Reports on Form 8-K 16 Signatures 17 </TABLE> Page 2
HERITAGE FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF INCOME (Dollars in thousands, except for per share data) (unaudited) <TABLE> <CAPTION> Three Months Ended Nine Months Ended September 30, September 30, 1999 2000 1999 2000 --------------------------- ------------------------- <S> <C> <C> <C> <C> INTEREST INCOME: Loans $8,519 10,609 23,801 30,371 Investment securities and FHLB dividends 679 643 2,151 1,946 Interest bearing deposits 63 46 735 148 ------ ------ ------ ------ Total interest income 9,261 11,298 26,687 32,465 INTEREST EXPENSE: Deposits 3,194 5,030 9,430 13,352 Borrowed funds 11 135 30 476 ------ ------ ------ ------ Total interest expense 3,205 5,165 9,460 13,828 ------ ------ ------ ------ Net interest income 6,056 6,133 17,227 18,637 PROVISION FOR LOAN LOSSES 102 195 306 585 ------ ------ ------ ------ Net interest income after provision for loan loss 5,954 5,938 16,921 18,052 NONINTEREST INCOME: Gains on sales of loans 209 189 935 483 Commissions on sales of annuities and securities 23 83 155 162 Service charges on deposits 349 425 1,023 1,179 Rental income 54 60 152 177 Other income 383 392 855 1,102 ------ ------ ------ ------ Total noninterest income 1,018 1,149 3,120 3,103 NONINTEREST EXPENSE: Salaries and employee benefits 2,396 2,445 7,257 7,683 Building occupancy 719 779 2,200 2,298 Data processing 322 303 929 911 Marketing 95 96 372 290 Goodwill Amortization 144 144 433 433 Business and occupation tax 141 151 462 424 Office supplies and printing 91 98 374 308 Other 907 809 2,336 2,200 ------ ------ ------ ------ Total noninterest expense 4,815 4,825 14,363 14,547 ------ ------ ------ ------ Income before federal income tax 2,157 2,262 5,678 6,608 Federal income tax 777 756 2,060 2,169 ------ ------ ------ ------ Net income $1,380 1,506 3,618 4,439 ====== ====== ====== ====== Earnings per share: Basic $0.128 0.172 0.335 0.479 Diluted $0.126 0.169 0.329 0.471 </TABLE> See Notes to Condensed Consolidated Financial Statements. Page 3
HERITAGE FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Dollars in thousands) (Unaudited) <TABLE> <CAPTION> December 31, September 30, 1999 2000 -------------------------------------- <S> <C> <C> Assets Cash on hand and in banks $ 17,596 16,503 Interest earning deposits 949 24 Federal funds sold 2,100 200 Investment securities available for sale 36,378 36,092 Investment securities held to maturity 6,165 5,513 Loans held for sale 589 2,902 Loans receivable 417,173 468,693 Less: Allowance for loan losses (4,264) (4,889) -------------------------------------- Loans, net 412,909 463,804 Premises and equipment, net 18,874 19,753 Federal Home Loan Bank stock 2,218 2,604 Accrued interest receivable 2,938 3,725 Prepaid expenses and other assets 2,447 3,233 Goodwill 7,795 7,362 -------------------------------------- Total assets $ 510,958 561,715 ====================================== Liabilities and Stockholders' Equity Deposits 405,068 458,273 Advances from Federal Home Loan Bank 2,800 11,160 Other borrowings 8 - Advance payments by borrowers for taxes and insurance 375 563 Accrued expenses and other liabilities 6,584 5,553 Deferred Federal income taxes 859 885 -------------------------------------- Total liabilities 415,694 476,434 Stockholders' equity: Common stock, no par value per share,15,000,000 shares authorized; 10,025,407 shares and 8,549,332 outstanding, respectively 69,837 57,310 Unearned compensation ESOP and Other (1,154) (1,096) Retained earnings, substantially restricted 26,926 29,253 Accumulated other comprehensive loss (345) (186) -------------------------------------- Total stockholders' equity 95,264 85,281 Commitments and contingencies - - -------------------------------------- Total liabilities and stockholders' equity $ 510,958 561,715 ====================================== </TABLE> See Notes to Condensed Consolidated Financial Statements. Page 4
HERITAGE FINANCIAL CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME Nine Months Ended September 30, 2000 (Amounts in Thousands) (Unaudited) <TABLE> <CAPTION> Number Unearned Accumulated of compensation other Total common Common ESOP and Retained comprehensive stockholders' shares stock other earnings income equity --------------------------------------------------------------------------------------- <S> <C> <C> <C> <C> <C> <C> Balance at December 31, 1999 10,025 $ 69,837 (1,154) 26,926 (345) 95,264 Earned ESOP shares - (5) 58 - - 53 Stock repurchase (1,510) (12,636) (12,636) Exercise of stock options 34 114 - - - 114 Net income - - - 4,439 - 4,439 Decrease in unrealized loss on securities available for sale, net of tax of $82 - - - - 159 159 Cash dividend declared - - - (2,112) - (2,112) ------------------------------------------------------------------------------------ Balance at September 30, 2000 8,549 $ 57,310 (1,096) 29,253 (186) 85,281 ==================================================================================== </TABLE> <TABLE> <CAPTION> Three months ended Nine months ended Comprehensive Income September 30, September 30, 1999 2000 1999 2000 ---------------- ----------------- -------------------- ------------------ <S> <C> <C> <C> <C> Net income $ 1,380 $ 1,506 $ 3,618 $ 4,439 Change in unrealized gain (loss) on securities available for sale, net of tax of $17, $101, ($162) and $82 33 197 (315) 159 -------------------------------------------------------------------------- Comprehensive income $ 1,413 $ 1,703 $ 3,303 $ 4,598 ========================================================================== </TABLE> See Notes to Condensed Consolidated Financial Statements. Page 5
HERITAGE FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (Unaudited) <TABLE> Nine Months Ended September 30, ------------------------- 1999 2000 <S> <C> <C> Cash flows from operating activities: Net income $ 3,618 4,439 Adjustments to reconcile net income to net cash provided by(used in) operating activities Amortization of goodwill 439 433 Depreciation and amortization 1,199 1,002 Deferred loan fees, net of amortization (129) (84) Provision for loan losses 306 585 Net (increase)decrease in loans held for sale 5,783 (2,313) Federal Home Loan Bank stock dividends (117) (111) Recognition of compensation related to ESOP 51 53 Net change in accrued interest receivable, prepaid expenses and other assets, and accrued expenses and other liabilities 258 (2,645) ------------------------- Net cash provided by(used in) operating activities 11,408 1,359 ------------------------- Cash flows from investing activities: Loans originated, net of principal payments and loan sales (73,097) (51,396) Proceeds from maturities of investment securities available for sale 7,247 730 Proceeds from maturities of investment securities held to maturity 8,777 656 Purchase of investment securities available for sale (12,557) (476) Purchase of investment securities held to maturity (155) - Purchase of premises and equipment (1,746) (1,884) ------------------------- Net cash used in investing activities (71,531) (52,370) ------------------------- Cash flows from financing activities: Net (increase)decrease in deposits (11,399) 53,205 Net (increase)decrease in borrowed funds (695) 8,352 Net decrease in advance payment by borrowers for taxes and insurance (104) 188 Cash dividends paid (1,733) (2,130) Proceeds from exercise of stock options 199 114 Stock repurchased (856) (12,636) ------------------------- Net cash provided by (used in) financing activities (8,418) 47,093 ------------------------- Net decrease in cash and cash equivalents (51,705) (3,918) Cash and cash equivalents at beginning of period 70,948 20,645 ------------------------- Cash and cash equivalents at end of period $ 19,243 16,727 ========================= Supplemental disclosures of cash flow information: Cash payments for: Interest expense $ 9,256 13,114 Federal income taxes 2,023 2,321 </TABLE> See Notes to Condensed Consolidated Financial Statements. Page 6
HERITAGE FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Nine Months Ended September 30, 1999 and 2000 (Unaudited) NOTE 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION (a.) Description of Business Heritage Financial Corporation (the Company) is a bank holding company incorporated in the State of Washington in August 1997. The Company was organized for the purpose of acquiring all of the capital stock of Heritage Bank upon its reorganization from a mutual holding company form of organization to a stock holding company form of organization. The Company is primarily engaged in the business of planning, directing and coordinating the business activities of its wholly owned subsidiaries: Heritage Bank (HB) and Central Valley Bank (CVB). Heritage Bank is a Washington State- chartered savings bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Savings Association Insurance Fund (SAIF). HB conducts business from its main office in Olympia, Washington and its eleven branch offices located in Thurston, Pierce and Mason Counties. Central Valley Bank is a national bank whose deposits are insured by the FDIC under the Bank Insurance Fund (BIF). CVB conducts business from its main office in Toppenish, Washington and its five branch offices located in Yakima and Kittitas Counties. The Company's business consists primarily of focusing on lending and deposit relationships with small businesses and their owners in its market area, attracting deposits from the general public and originating for sale or investment purposes first mortgage loans on residential properties located in western and central Washington State. The Company also makes residential construction loans, income property loans and consumer loans. (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 our December 31, 1999 audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K. In our opinion, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2000 are not necessarily indicative of the results that may be expected for the year ending December 31, 2000. In preparing the consolidated financial statements, we are required to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results could differ from those estimates. (c.) Recently Issued Accounting Pronouncements In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities". This statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. In May 1999, the Financial Accounting Standards Board delayed the effective date of SFAS No. 133 to fiscal years beginning after June 15, 2000, with interim reporting required. In June 2000, the FASB issued SFAS Statement No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities", an amendment of Page 7
FASB Statement No. 133, which makes minor modifications to SFAS No. 133. We do not expect that the application of SFAS 133 or 138 will have a material effect on our financial position or the results of operations. The SEC issued Staff Accounting Bulletin No. 101B (SAB 101B). SAB 101B delays the effective date of Staff Accounting Bulletin No. 101 (SAB 101) "Revenue Recognition in Financial Statements", to the fourth quarter for fiscal years beginning between December 15, 1999 and March 16, 2000. SAB 101 provides guidance for revenue recognition and the SEC staff's views on the application of accounting principles to selected revenue recognition issues. We will adopt the provisions of SAB 101 in the fourth quarter of 2000 and anticipate that such adoption will not have a material impact on our consolidated financial statements. In March 2000, the Financial Accounting Standards Board issued Interpretation No. 44, "Accounting for Certain Transactions involving Stock Compensation". Interpretation No. 44 clarifies the application of Accounting Principles Board Opinion No. 25 (APB 25) and became effective July 1, 2000. Interpretation No. 44 clarifies the definition of "employee" for purposes of applying APB 25, the criteria for determining whether a plan qualifies as a noncompensatory plan, the accounting consequence of various modifications to the terms of a previously fixed stock option or award, and the accounting for an exchange of stock compensation awards in a business combination. We adopted Interpretation No. 44 on July 1, 2000, and it did not have a material impact on our consolidated financial statements. NOTE 2. STOCKHOLDERS' EQUITY a. Earnings per Share The following table illustrates the reconciliation of weighted average shares used for earnings per share for the applicable periods. <TABLE> <CAPTION> Three months ended Nine months ended September 30, September 30, 1999 2000 1999 2000 ----------------------------------------------------------- <S> <C> <C> <C> <C> Basic: Weighted average shares outstanding 10,791,666 8,737,695 10,818,576 9,290,418 Diluted: Basic weighted average shares outstanding 10,791,666 8,737,695 10,818,576 9,290,418 Incremental shares from unexercised stock options 185,472 172,803 190,694 145,521 ----------------------------------------------------------- Weighted average shares outstanding 10,977,138 8,910,498 11,009,270 9,435,939 =========================================================== </TABLE> As of September 30, 2000 and 1999 there were anti dilutive options of 96,150 and 92,700 respectively, which were not included in the calculation. b. Cash Dividend Declared On September 21, 2000, we announced a quarterly cash dividend of 8.5 cents per share payable on October 27, 2000 to stockholders of record on October 16, 2000. c. Shares Repurchased Page 8
As of September 30, 2000 we have repurchased 1,510,000 shares of Heritage Financial Corporation stock at a cost of $12,636,000 during the current fiscal year. On August 16, 2000, our Board of Directors announced that it authorized management to repurchase an additional 10% of our outstanding shares subject to regulatory approval. This represents the third stock repurchase program since October 1999 and is expected to be completed over an eighteen month period. Page 9
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 Heritage Financial Corporation. 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, 1999 audited consolidated financial statements and notes thereto included in our recent Annual Report on Form 10-K. 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 our financial results, are included in filings by the company with the Securities and Exchange Commission. Overview Beginning in 1994, we began to implement a growth strategy which is intended to broaden our 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, we closed our second step conversion and stock offering which resulted in $63 million in net proceeds. Thereafter, our common stock began to trade on the Nasdaq National Market under the symbol "HFWA". Financial Condition Data Total assets increased $50.7 million (10%) during the nine months ended September 30, 2000 to $561.7 million from the December 31, 1999 balance of $511.0 million. The asset growth was in lending as net loans increased $53.2 million (13%) to $466.7 million at September 30, 2000 from $413.5 million at December 31, 1999. Consistent with management's efforts to continue to increase our business customer base, commercial loans provided $36.0 million of that growth. To support the growth in lending, deposits increased $53.2 million (13%) for the nine months ended September 30, 2000 to $458.3 million from the December 31, 1999 balance of $405.1 million. Other borrowings increased $8.4 million to $11.2 million at September 30, 2000 from $2.8 million at December 31, 1999. The Company also reduced equity during the nine months ended September 30, 2000 by repurchasing 1.5 million shares of common stock, reducing equity by $12.6 million. Earnings Summary Net income for the nine months ended September 30, 2000 was $4,439,000, or $0.471 per diluted share, compared to $3,618,000, or $0.329 per diluted share, for the same period last year representing an increase of 23% in actual earnings and 43% in diluted earnings per share. The difference in the percentage change for actual earnings and earnings per share is the result of the stock repurchase program. The year to date increase in net income was primarily attributable to Page 10
growth in the net interest income resulting from earning assets growth. Net income for the three months ended September 30, 2000 was $1,506,000, or $0.169 per diluted share, compared to $1,380,000, or $0.126 per diluted share, for the same period last year representing an increase of 9% in actual earnings and 34% in earnings per share. The quarterly increase in net income was primarily attributable to increased fee income from growth in deposit and service activities. Cash earnings, which exclude the amortization of goodwill recorded on the acquisition of North Pacific Bank, for the nine months ended September 30, 2000 were $4,724,000, or $0.501 per diluted share compared with $3,908,000, or $0.355 per diluted share for the same nine month period in 1999. Cash earnings for the quarter ended September 30, 2000 were $1,602,000, or $0.179 per diluted share compared with $1,477,000, or $0.135 per diluted share for the quarter ended September 30, 1999. Net Interest Income Net interest income before provision for loan loss for the nine months ended September 30, 2000, increased 8.2% to $18,637,000 from $17,227,000. For the three months ended September 30, 2000, net interest income before provision increased 1.3% to $6,133,000 from $6,056,000 for the same quarter in 1999. This increase was due to the expansion of gross loans to $471.6 million at September 30, 2000 from $394.5 million at September 30, 1999. Net interest margin (net interest income divided by average interest earning assets) narrowed to 5.13% for the nine months ended September 30, 2000 from 5.50% for the nine months ended September 30, 1999. The lower margin resulted from increased use of higher costing funds to support our loan growth and reduced capital through the stock repurchase. Certificates of Deposit averaged $220.3 million costing 5.86% for the first nine months of 2000, compared with $159.7 million costing 4.95% for the same period in 1999. Our overall cost of funds increased to 4.72% for the nine months ended September 30, 2000, from 3.96% for the nine months ended September 30, 1999. The net interest margin narrowed to 4.92% for the current quarter from 5.64% for the same quarter last year. Certificates of Deposit averaged $233.7 million costing 6.34% for the quarter ended September 30, 2000, compared to $162.2 million in average balances costing 4.88% for the same quarter in 1999. Our overall cost of funds increased to 5.08% for the quarter ended September 30, 2000, from 3.92% for the quarter ended September 30, 1999. Provision for Loan Losses For the nine months ended September 30, 2000 the loan loss provision was $585,000 compared with $306,000 for the nine months ended September 30, 1999. The quarterly provision for loan losses was $195,000 for the current quarter up from $102,000 for the September 1999 quarter. We believe that the increase is prudent to ensure that we maintain our allowance for loan losses at an adequate level to reflect our loan growth and the changes in our loan portfolio mix. Noninterest Income Noninterest income decreased 0.5% to 3,103,000 for the nine months ended September 30, 2000 compared with $3,120,000 for the same period in 1999. The decrease is the result of reduced activity in mortgage banking. Loan sale gains were $483,000 for the nine months ended September 30, 2000 compared with $935,000 for the nine months ended September 30, 1999. The Page 11
impact was most prominent in the first quarter where the gains were $95,000 for the quarter ended March 31, 2000 compared to $432,000 for the quarter ended March 31, 1999. Noninterest income for the quarter ended September 30, 2000 increased 13.0% to $1,149,000 compared with $1,018,000 for the same quarter in 1999. This increase resulted from additional income from service charges on deposits and fee product commissions. Service charges on deposits increased 22% to $425,000 for the quarter ended September 30, 2000 compared to $349,000 for the quarter ended September 30, 1999. Fee product commissions increased 260% to $83,000 for the quarter ended September 30, 2000 compared to $23,000 for the quarter ended September 30, 1999 due to low production of fee product sales in the third period of 1999. Noninterest Expense Noninterest expense increased 1.3% to $14,547,000 for the nine months ended September 30, 2000 compared to $14,363,000 for the nine months ended September 30, 1999. Noninterest expense increased a slight 0.2% to $4,825,000 for the quarter ended September 30, 2000 compared to $4,815,000 for quarter ended September 30, 1999. The efficiency ratio for the nine months ended September 30, 2000 improved to 66.92% from 70.59% for the comparable nine month period in 1999. The efficiency ratio for the quarter ended September 30, 2000 improved to 66.26% from 68.06% for the comparable quarter in 1999. The improvement resulted from increased revenue coupled with flat noninterest expense. Lending Activities Commercial loans now represent the largest segment of our loan portfolio. As indicated in the table below, total loans increased to $471.6 million at September 30, 2000 from $417.8 million at December 31, 1999. <TABLE> <CAPTION> (in thousands) At At December 31, % of September 30, % of 1999 Total 2000 Total ---------------------------------------------------------- <S> <C> <C> <C> <C> Commercial $192,088 45.98% 228,044 48.36% Real estate mortgages One-to-four family residential 97,907 23.44 106,367 22.55 Five or more family and commercial properties 94,242 22.56 106,924 22.67 -------------------------------------------------------- Total real estate mortgages 192,149 46.00 213,291 45.22 Real estate construction One-to-four family residential 23,293 5.58 24,847 5.27 Five or more family and commercial properties 7,537 1.80 1,321 0.28 -------------------------------------------------------- Total real estate construction 30,830 7.38 26,168 5.55 Consumer 4,273 1.02 5,754 1.22 -------------------------------------------------------- Gross loans 419,340 100.38% 473,257 100.35% Less: deferred loan fees (1,578) (0.38) (1,662) (0.35) -------------------------------------------------------- Total loans $417,762 100.00% 471,595 100.00% ======================================================== </TABLE> Nonperforming Assets The following table sets forth the amount of our nonperforming assets at the dates indicated. Page 12
<TABLE> <CAPTION> At At December 31, September 30, 1999 2000 ------------------------------------------ (Dollars in thousands) <S> <C> <C> Nonaccrual loans $ 1,804 1,657 Restructured loans - - ------------------------------------------ Total nonperforming loans 1,804 1,657 Real estate owned - - ------------------------------------------ Total nonperforming assets $ 1,804 1,657 ========================================== Accruing loans past due 90 days or more $ - - Potential problem loans 2,826 1,813 Allowance for loan losses 4,264 4,889 Nonperforming loans to loans 0.43% 0.35% Allowance for loan losses to loans 1.02% 1.04% Allowance for loan losses to nonperforming loans 236.27% 295.08% Nonperforming assets to total assets 0.35% 0.29% </TABLE> Nonperforming loans were down to $1,657,000, or 0.35% of total loans, at September 30, 2000 from $1,804,000, or 0.43% of total loans, at December 31, 1999. Analysis of Allowance for Loan Losses The allowance for loan losses is maintained at a level we consider adequate to provide for reasonably foreseeable loan losses based on our assessment of various factors affecting the loan portfolio, including a review of problem loans, business conditions and loss experience, 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 we believe that we use 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 summarizes the changes in our allowance for loan losses: <TABLE> <CAPTION> Nine Months Ended September 30, <S> <C> <C> 1999 2000 ----------------------------------------- (Dollars in thousands) Total loans outstanding at end of period (1) $ 394,491 471,595 Average loans outstanding during period 347,911 436,768 Allowance balance at beginning of period 3,957 4,264 Provision for loan losses 306 585 Charge-offs Real estate (1) Commercial (7) (3) Agriculture - (6) Consumer (5) (2) ----------------------------------------- Total charge-offs (13) (11) ----------------------------------------- Recoveries Real estate 16 22 Commercial 91 28 Agriculture - 1 Consumer 3 - ----------------------------------------- Total recoveries 110 51 ----------------------------------------- Net (charge-offs) recoveries 97 40 ----------------------------------------- Allowance balance at end of period $ 4,360 4,889 ========================================= Allowance for loan loss to loans at September 30, 1999 and 2000 1.11% 1.04% Ratio of net (charge-offs) recoveries during period to average loans outstanding 0.028% 0.009% ========================================= </TABLE> ____________ (1) Includes loans held for sale While pursuing our growth strategy, we will continue to employ prudent underwriting and sound loan monitoring procedures in order to maintain asset quality. The allowance for loan losses during the nine months ended September 30, 2000 increased $625,000 to $4.9 million. The growth in the allowance was due to the $585,000 provision and $40,000 in net recoveries during the period. Liquidity and Source of Funds Our primary sources of funds are customer deposits, public fund 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. We 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. We generally maintain sufficient cash and short term investments to meet short term liquidity needs. At September 30, 2000, cash and cash equivalents totaled $16.7 million (3.0% of Page 14
total assets), and investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $37.4 million (6.7% of total assets). At September 30, 2000, we maintained a combined credit facility with the FHLB of Seattle for Heritage Bank and Central Valley Bank of $104.7 million (of which $11.2 million was outstanding at that date). Capital Stockholders' equity at September 30, 2000 was $85.3 million compared with $95.3 million at December 31, 1999. During the period we repurchased $12.6 million of Heritage Financial Corporation stock, declared three cash dividends totaling $2.1 million (7.5 cents per share, to shareholders of record on April 14, 2000, 8.0 cents per share to shareholders of record on July 14, 2000, and 8.5 cents per share to shareholders of record on October 16, 2000), had year to date income of $4.4 million, recorded $158,000 in reduced unrealized losses on securities available for sale net of tax, and our employees and directors exercised stock options of $114,000. Banking regulations require bank holding companies and banks to maintain a minimum "leverage" ratio of core capital to adjusted quarterly average total assets of at least 3%. At September 30, 2000, our leverage ratio was 14.4%, compared with 18.8% at December 31, 1999. 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%. Our Tier I and total capital ratios were 16.9% and 17.9%, respectively, at September 30, 2000 compared with 21.1% and 22.1%, respectively, at December 31, 1999. 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 September 30, 2000. Quantitative and Qualitative Disclosures About Market Risk Our results of operations are highly dependent upon our ability to manage interest rate risk. We consider interest rate risk to be a significant market risk that could have a material effect on our financial condition and results of operations. In our opinion, there has been no material change in our interest rate risk exposure since our most recent year end at December 31, 1999. We do not maintain a trading account for any class of financial instrument, nor do we engage in hedging activities or purchase high risk derivative instruments. Moreover, we are not subject to foreign currency exchange rate risk or commodity price risk. Page 15
PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS There are no material pending legal proceedings to which the Company or any of its subsidiaries is a party which, if adversely decided, would have a material adverse effect on the financial condition of the Company. ITEM 2. CHANGES IN SECURITIES None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS OF FORM 8-K a. See EXHIBIT 27-Financial Data Schedule. b. There were no 8-K filings for the quarter ended September 30, 2000. Page 16
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. HERITAGE FINANCIAL CORPORATION Date: November 7, 2000 by /s/ Donald V. Rhodes -------------------------------------------------- Donald V. Rhodes Chairman, President and Chief Executive Officer (Duly Authorized Officer) by /s/ Edward D. Cameron -------------------------------------------------- Edward D. Cameron Vice President and Treasurer (Principal Financial and Accounting Officer) Page 17