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, 2001 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, 2001 the registrant had 7,703,930 common shares outstanding, with no par value. 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> Condensed Consolidated Statements of Income for the Three Months and Nine Months Ended September 30, 2000 and 2001 3 Condensed Consolidated Statements of Financial Condition As of December 31, 2000 and September 30, 2001 4 Condensed Consolidated Statements of Stockholders' Equity for the Nine Months Ended September 30, 2001 and Comprehensive Income for the Three and Nine Months Ended September 30, 2000 and 2001 5 Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2000 and 2001 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 16 PART II. Other Information - -------- ----------------- Item 6. Exhibits and Reports on Form 8-K 17 Signatures 18 </TABLE> Page 2
HERITAGE FINANCIAL CORPORATION CONDENSED 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, 2000 2001 2000 2001 --------------------- ------------------- <S> <C> <C> <C> <C> INTEREST INCOME: Loans $ 10,609 $10,718 $ 30,371 $ 32,763 Investment securities and FHLB dividends 643 386 1,946 1,301 Interest bearing deposits 46 108 148 300 -------- ------- -------- --------- Total interest income 11,298 11,212 32,465 34,364 INTEREST EXPENSE: Deposits 5,030 4,208 13,352 14,096 Borrowed funds 135 226 476 796 -------- ------- -------- --------- Total interest expense 5,165 4,434 13,828 14,892 -------- ------- -------- --------- Net interest income 6,133 6,778 18,637 19,472 PROVISION FOR LOAN LOSSES 195 290 585 807 -------- ------- -------- --------- Net interest income after provision for loan loss 5,938 6,488 18,052 18,665 NONINTEREST INCOME: Gains on sales of loans 189 377 483 1,168 Commissions on sales of annuities and securities 83 26 162 90 Service charges on deposits 425 565 1,179 1,407 Rental income 60 68 177 201 Other income 392 473 1,102 1,430 -------- ------- -------- --------- Total noninterest income 1,149 1,509 3,103 4,296 NONINTEREST EXPENSE: Salaries and employee benefits 2,445 2,372 7,683 7,783 Building occupancy 779 836 2,298 2,474 Data processing 303 266 911 788 Marketing 96 102 290 295 Office supplies and printing 98 112 308 314 Goodwill Amortization 144 144 433 433 Other 960 954 2,624 3,491 -------- ------- -------- --------- Total noninterest expense 4,825 4,786 14,547 15,578 -------- ------- -------- --------- Income before federal income taxes 2,262 3,211 6,608 7,383 Federal income taxes 756 1,132 2,169 2,631 -------- ------- -------- --------- Net income $ 1,506 $ 2,079 $ 4,439 $ 4,752 ======== ======= ======== ========= Earnings per share: Basic $ 0.172 $ 0.266 $ 0.479 $ 0.589 Diluted $ 0.169 $ 0.261 $ 0.471 $ 0.577 </TABLE> See Notes to Condensed Consolidated Financial Statements. Page 3
HERITAGE FINANCIAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Dollars in thousands) (Unaudited) <TABLE> <CAPTION> December 31, September 30, 2000 2001 ------------- ------------- ASSETS <S> <C> <C> Cash on hand and in banks $ 20,187 $ 20,983 Interest earning deposits 1,278 2,088 Federal funds sold - 3,425 Investment securities available for sale 33,695 22,205 Investment securities held to maturity 5,076 3,901 Loans held for sale 1,931 6,905 Loans receivable 480,504 500,759 Less: Allowance for loan losses (5,063) (5,802) ------------ ------------ Loans, net 475,441 494,957 Real Estate Owned - 1,029 Premises and equipment, net 19,510 19,114 Federal Home Loan Bank stock and Federal Reserve Stock 2,723 2,862 Accrued interest receivable 3,693 3,499 Prepaid expenses and other assets 2,779 4,067 Goodwill 7,217 6,784 ------------ ------------- Total assets $ 573,530 $ 591,819 ============ ============= LIABILITIES AND STOCKHOLDER'S EQUITY Deposits 460,234 489,588 Advances from Federal Home Loan Bank 23,125 15,350 Other borrowings 1,000 - Advance payments by borrowers for taxes and insurance 363 35 Accrued expenses and other liabilities 5,037 6,566 Deferred Federal income taxes 766 894 ------------ ------------ Total liabilities 490,525 512,433 Stockholders' equity: Common stock, no par value per share,15,000,000 shares authorized; 8,222,988 shares and 7,704,121 outstanding at December 31, 2000 and September 30, 2001, respectively 54,080 47,736 Unearned compensation-ESOP and Other (1,074) (998) Retained earnings, substantially restricted 30,000 32,401 Accumulated other comprehensive loss (1) 247 ------------ ------------ Total stockholders' equity 83,005 79,386 Commitments and contingencies - - ------------ ------------ Total liabilities and stockholders' equity $ 573,530 $ 591,819 ============ ============ </TABLE> See Notes to Condensed Consolidated Financial Statements. Page 4
HERITAGE FINANCIAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME Nine Months Ended September 30, 2001 (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, 2000 8,223 $ 54,080 $(1,074) $30,000 $ (1) $83,005 Earned ESOP shares 7 2 76 - - 78 Stock repurchase (622) (6,729) - - - (6,729) Exercise of stock options 97 383 - - - 383 Net income - - - 4,752 - 4,752 Increase in unrealized gain on securities available for sale, net of tax of $127 - - - - 248 248 Cash dividend declared - - - (2,351) - (2,351) ------------------------------------------------------------------------------------------ Balance at September 30, 2001 7,704 $ 47,736 $ (998) $32,401 $247 $79,386 ========================================================================================== </TABLE> <TABLE> <CAPTION> Three months ended Nine months ended Comprehensive Income September 30, September 30, 2000 2001 2000 2001 ---------------------------------------------------------------- <S> <C> <C> <C> <C> Net income $ 1,506 $ 2,079 $ 4,439 $ 4,752 Increase in unrealized gain on securities available for sale, net of tax of $101, $51, $82 and $127 197 99 159 248 --------------- ---------------- ------------ ------------ Comprehensive income $ 1,703 $ 2,178 $ 4,598 $ 5,000 =============== ================ ============ ============ </TABLE> See Notes to Consolidated Financial Statements. Page 5
HERITAGE FINANCIAL CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in thousands) (Unaudited) <TABLE> <CAPTION> Nine Months Ended September 30, 2000 2001 --------------------- <S> <C> <C> Cash flows from operating activities: Net income $ 4,439 $ 4,752 Adjustments to reconcile net income to net cash provided by operating activities Goodwill amortization 433 433 Depreciation and amortization 1,002 1,168 Deferred loan fees, net of amortization (84) 66 Provision for loan losses 585 807 Net increase in loans held for sale (2,313) (4,974) Federal Home Loan Bank stock dividends and Federal Reserve Stock (111) (139) Recognition of compensation related to ESOP 53 78 Net change in accrued interest receivable, prepaid expenses and other assets, and accrued expenses and other liabilities (2,645) 496 -------------------- Net cash provided by operating activities 1,359 2,687 -------------------- Cash flows from investing activities: Loans originated, net of principal payments and loan sales (51,396) (21,418) Proceeds from maturities of investment securities available for sale 730 43,522 Proceeds from maturities of investment securities held to maturity 656 1,705 Purchase of investment securities available for sale (476) (31,973) Purchase of investment securities held to maturity -- (185) Purchase of premises and equipment (1,884) (864) -------------------- Net cash used in investing activities (52,370) (9,213) -------------------- Cash flows from financing activities: Net increase in deposits 53,205 29,354 Net increase (decrease) in borrowed funds 8,352 (8,775) Net increase (decrease) in advance payment by borrowers for taxes and insurance 188 (328) Cash dividends paid (2,130) (2,348) Proceeds from exercise of stock options 114 383 Stock repurchased (12,636) (6,729) -------------------- Net cash provided by financing activities 47,093 11,557 -------------------- Net increase (decrease) in cash and cash equivalents (3,918) 5,031 Cash and cash equivalents at beginning of period 20,645 21,465 -------------------- Cash and cash equivalents at end of period $ 16,727 $ 26,496 ==================== Supplemental disclosures of cash flow information: Cash payments for: Interest expense $ 13,587 $ 15,241 Federal income taxes 2,321 2,037 Loans transferred to real estate owned -- 1,029 </TABLE> See Notes to Condensed Consolidated Financial Statements. Page 6
HERITAGE FINANCIAL CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Nine Months Ended September 30, 2000 and 2001 (Unaudited) NOTE 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION (a.) Description of Business Heritage Financial Corporation is a bank holding company incorporated in the State of Washington in August 1997. We were 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. We are primarily engaged in the business of planning, directing, and coordinating the business activities of our wholly owned subsidiaries: Heritage Bank (HB) and Central Valley Bank (CVB). Heritage Bank is a Washington-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. Our business consists primarily of focusing on lending and deposit relationships with small businesses and their owners in our 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. We also make 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 accounting principles generally accepted in the United States of America for complete financial statements. These consolidated financial statements should be read in conjunction with our December 31, 2000 audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K. In our opinion, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2001 are not necessarily indicative of the results that may be expected for the year ending December 31, 2001. 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 September 2000, the Financial Accounting Standards Board issued SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," and replaced SFAS No. 125 of the same title. This statement revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires certain disclosures, but carries over most of SFAS No. 125's provisions without reconsideration. This statement is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001 and is effective for recognition and reclassification of collateral and for disclosures relating to securitization transactions and collateral for fiscal years ending after December Page 7
15, 2000. We have adopted SFAS Statement No. 140 and it did not have a material impact on our consolidated financial statements. In July 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 141 "Business Combinations" and SFAS No. 142 "Goodwill and Other Intangible Assets". SFAS No. 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting, and broadens the criteria for recording intangible assets separate from goodwill. Recorded goodwill and intangibles will be evaluated against this new criteria and may result in certain intangibles being included in goodwill. Alternatively, certain amounts initially recorded as goodwill may be separately identified and recognized apart from goodwill. SFAS No. 142 requires the use of a nonamortization approach to account for purchased goodwill and certain intangibles. Under a nonamortization approach, goodwill and certain intangibles will not be amortized into results of operations, but instead would be reviewed for impairment and written down and charged to results of operations only in the periods in which the recorded value of goodwill and certain intangibles is more than its fair value. The provisions of each statement, which apply to goodwill and intangible assets acquired prior to June 30, 2001 will be adopted by the Company on January 1, 2002. As of the date of adoption, the Company expects to have unamortized goodwill in the amount of $6,640,000, which will be subject to the transition provisions of SFAS 141 and 142. In June 2001, the Financial Accounting Standards Board issued Statement No. 143, "Accounting for Asset Retirement Obligations", which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) normal use of the asset. Statement No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset and this additional carrying amount is depreciated over the life of the asset. The liability is accreted at the end of each period through charges to operating expense. If the obligation is settled for other than the carrying amount of the liability, the Company will recognize a gain or loss on settlement. The Company is required and plans to adopt the provisions of Statement No. 143 for the quarter ending March 31, 2003. Management has not yet determined the impact of adopting this Statement. In August 2001, the Financial Accounting Standards Board (FASB or the Board) issued FASB Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which addresses financial accounting and reporting for the impairment or disposal of long-lived assets. While Statement No. 144 supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", it retains many of the fundamental provisions of that Statement. Statement No. 144 also supersedes the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations--Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions", for the disposal of a segment of a business. However, it retains the requirement in Opinion No. 30 to report separately discontinued operations and extends that reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. The Company is required and plans to adopt the provisions of Statement No. 144 for the fiscal year beginning January 1, 2002. Page 8
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, 2000 2001 2000 2001 ------------------------------------------------------------ <S> <C> <C> <C> <C> Basic: Weighted average shares outstanding 8,737,695 7,807,216 9,290,418 8,067,527 Diluted: Basic weighted average shares outstanding 8,737,695 7,807,216 9,290,418 8,067,527 Incremental shares from unexercised stock options 172,803 166,788 145,521 168,234 ------------------------------------------------------------ Weighted average shares outstanding 8,910,498 7,974,003 9,435,939 8,235,761 ============================================================ </TABLE> As of September 30, 2001 and 2000 there were anti-dilutive shares of 69,600 and 96,150 respectively, excluded from the above disclosure. b.) Cash Dividend Declared On September 28, 2001, we announced a quarterly cash dividend of 10.5 cents per share payable on October 29, 2001 to stockholders of record on October 15, 2001. 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 with the unaudited Condensed Consolidated Financial Statements and its accompanying Notes, and the December 31, 2000 audited consolidated financial statements and notes 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". Heritage Bank initiated a major effort to improve efficiency and to enhance our revenue stream in November of 2000. We called this initiative "Vision 2001". We engaged Alex Sheshunoff Management Services, L.P. (ASM) to assist us in this effort. ASM completed an Opportunities Assessment with the objective of determining ways that we can optimize our earnings performance and in March 2001, ASM began working with us to implement the opportunities identified. We incurred the majority of the expenses associated with this project during the first and second quarter of this year. We began to realize benefits in the form of revenue enhancements and reduced expenses during the third quarter. We expect the benefits to continue throughout future periods. Financial Condition Data Total assets increased $18.3 million (3%) during the nine months ended September 30, 2001 to $591.8 million from the December 31, 2000 balance of $573.5 million. The asset growth was in lending as net loans increased $19.6 million (4%) to $495.0 million at September 30, 2001 from $475.4 million at December 31, 2000. Consistent with management's efforts to increase our business customer base, commercial loans grew $26.4 million during that period. Commercial loans continue to be the largest segment of the loan portfolio at 51.3% and 48.5% as a percentage of total loans at September 30, 2001 and December 31, 2000, respectively. Deposits increased $29.4 million (6%) for the nine months ended September 30, 2001 to $489.6 million from $460.2 million as Page 10
of December 31, 2000. Borrowings decreased $7.7 million to $15.4 million at September 30, 2001 from $23.1 million at December 31, 2000. In addition to the 100,000 shares repurchased in April 1999, we started the first of four 10% stock repurchase programs in October 1999. As of September 30, 2001, we repurchased a total of 3,299,403 shares, or 30.0% of the total outstanding at March 1999 at an average price of $9.00 per share. During the quarter ended September 30, 2001, 172,765 shares were repurchased at an average price of $11.52. We began our fourth, and current, 10% repurchase program in May 2001 with a target to repurchase approximately 800,000 shares over a period of eighteen months. Through September 30, 2001, 347,112 shares were repurchased or 43.4% of the fourth program at an average price of $11.05. Earnings Summary Net income for the three months ended September 30, 2001 was $2,079,000, or $0.261 per diluted share, compared to $1,506,000 or $0.169 per diluted share for the same period last year, resulting in an increase in net income of 38.0% and an increase in per diluted share earnings of 54.4%. The increase is predominately due to the "Vision 2001" initiative, which led to reduced expenses and enhanced revenue. The expenses associated with "Vision 2001" were primarily incurred during the first half of 2001 and the revenue enhancements and expense control have produced very tangible results during the third quarter. Net income for the nine months ended September 30, 2001 was $4,752,000 or $0.577 per diluted share compared with $4,439,000 or $0.471 per diluted share for the same period in 2000, an increase in net income of 7.0% and per diluted share earnings of 22.5%. The significant increase in per diluted share earnings is a result of the ongoing stock repurchase program, which continues to be accretive to earnings per share. Cash earnings for the quarter ended September 30, 2001, which exclude the amortization of goodwill recorded on the acquisition of North Pacific Bank, were $2,224,000, or $0.270 per diluted share compared with $1,651,000 or $0.185 per diluted share for the quarter ended September 30, 2000. Cash earnings for the nine months ended September 30, 2001 were $5,185,000, or $0.630 per diluted share compared with $4,872,000, or $0.516 per diluted share for the same nine month period in 2000. Net Interest Income Net interest income before provision for loan loss for the three months ended September 30, 2001 increased 10.5% to $6,779,000 compared to $6,133,000 for the same period in 2000. Net interest income before provision for loan loss for the nine months ended September 30, 2001, increased 4.5% to $19,472,000 compared to $18,637,000 for the nine months ended September 30, 2000. The increase was primarily due to increased average loan balances as total loans increased 7.6% from $471.6 million at September 30, 2000 to $507.7 million at September 30, 2001. Net interest margin (net interest income divided by average interest earning assets) increased to 5.04% for the quarter ended September 30, 2001 compared to 4.92% for the quarter ended September 30, 2000. The third quarter increase in margin is primarily due to our ability to proactively manage our liability costs. For the nine month period ended September 30, 2001, the net interest margin narrowed to 4.88% from 5.13% for the nine month period ended September 30, 2000. The decrease in margin for the nine month period is due to a sharply reduced prime rate from the beginning of the year and the continued reduction of capital through the stock repurchase program. The average cost of funds for the three month period ended September 30, 2001 declined 23% to Page 11
3.91% from 5.08% for the quarter ended September 30, 2000. The average cost of funds for the nine months ended September 30, 2001 declined 6% to 4.43% from 4.72% for the nine months ended September 30, 2000. The declines in average cost of funds for both periods is due to the continual decline in rates and our significant opportunities to reprice certificates of deposits during the first three quarters of 2001. Average equity declined 8% to $80.8 million for the three months ended September 30, 2001 compared to $87.2 million for the three months ended September 30, 2000. For the nine months ended September 30, 2001, average equity declined 10% to $82.1 million from $90.9 million for the nine months ended September 30, 2000. Provision for Loan Losses The quarterly provision for loan losses was $290,000 for the current quarter up from $195,000 for the September 2000 quarter. For the nine months ended September 30, 2001, the loan loss provision was $807,000 compared with $585,000 for the nine months ended September 30, 2000. Our commercial loan portfolio now represents 51.3% of our total loans (up from 48.5% at year end 2000 and 45.9% at year end 1999) and with the inherent risks present in our commercial loan portfolio as demonstrated by the loan loss experience of other commercial banks, we believe the increase is prudent and necessary to maintain our allowance for loan losses at an acceptable level. Noninterest Income Noninterest income increased 31% to $1,509,000 for the quarter ended September 30, 2001 compared to $1,149,000 for the same quarter in 2000. For the nine months ended September 30, 2001, noninterest income was $4,296,000, compared to $3,103,000 for the same period in 2000, an increase of 38%. The growth was due to increased loan sale gains from our mortgage banking activity, increased service charges on deposits, and gains on sales of investments and assets. Loan sale gains were $1,168,000 for the nine months ended September 30, 2001 compared to $483,000 for the nine months ended September 30, 2000, an increase of $685,000. Service charges on deposits increased 19% to $1,407,000 for the nine months ended September 30, 2001, compared to $1,179,000 for the same period in 2000. The increase in service charges on deposits was largely a result of changes arising from "Vision 2001" to Heritage Bank's deposit products. In addition, increased noninterest income was generated from the sale of our ownership interest in Transalliance Corporation (a debit/credit card processor), which resulted in a year to date pre-tax gain of $157,000; and the sale of excess land at Central Valley Bank's Toppenish office, which resulted in a pre-tax gain of $66,000. Noninterest Expense Noninterest expense decreased to $4,786,000 for the quarter ended September 30, 2001 from $4,825,000 for the quarter ended September 30, 2000, a decrease of 0.8%. Noninterest expense increased 7.1% to $15,578,000 for the nine months ended September 30, 2001 compared to $14,547,000 for the nine months ended September 30, 2000. "Vision 2001" after-tax expenses totaled $389,000, which were incurred by the end of the second quarter. The third quarter decline in noninterest expense was a result of "Vision 2001" cost saving initiatives. The efficiency ratio for the quarter ended September 30, 2001 improved to 57.75% from 66.26% for the comparable quarter in 2000. The efficiency ratio for the nine months ended September 30, 2001 improved to 65.54% from 66.92% for the comparable nine month period in 2000. The improvement in the efficiency ratio was Page 12
due to "Vision 2001", which focused on reduced levels of noninterest expense and enhanced noninterest income. Lending Activities Since initiating our expansion activities in 1994, we have supplemented our traditional mortgage loan products with an increased emphasis on commercial loans. As a result, our commercial loan portfolio is a significant portion of our loan portfolio. As indicated in the table below, total loans increased to $507.7 million at September 30, 2001 from $482.4 million at December 31, 2000. <TABLE> <CAPTION> (in thousands) At At December 31, % of September 30, % of 2000 Total 2001 Total ------------------------------------------------------------ <S> <C> <C> <C> <C> Commercial $ 234,166 48.55 % $ 260,532 51.33 % Real estate mortgages One-to-four family residential 107,501 22.28 101,657 20.02 Five or more family and commercial properties 109,560 22.71 104,064 20.50 ------------------------------------------------------------ Total real estate mortgages 217,061 44.99 205,721 40.52 Real estate construction One-to-four family residential 27,412 5.68 37,487 7.38 Consumer 5,466 1.13 5,330 1.05 ------------------------------------------------------------ Gross loans 484,105 100.35 509,070 100.28 Less: deferred loan fees (1,670) (0.35) (1,406) (0.28) ------------------------------------------------------------ Total loans $ 482,435 100.00 % $ 507,664 100.00 % ============================================================ </TABLE> Nonperforming Assets The following table sets forth the amount of our nonperforming assets at the dates indicated. <TABLE> <CAPTION> At At December 31, September 30, 2000 2001 ----------------------------------- (Dollars in thousands) <S> <C> <C> Nonaccrual loans $ 1,607 $ 2,225 Restructured loans - - ----------------------------------- Total nonperforming loans 1,607 2,225 Real estate owned - 1,029 ----------------------------------- Total nonperforming assets $ 1,607 $ 3,254 =================================== Accruing loans past due 90 days or more $ 1,086 $ 336 Potential problem loans $ 2,422 $ 4,100 Allowance for loan losses $ 5,063 $ 5,802 Nonperforming loans to loans 0.33% 0.44% Allowance for loan losses to loans 1.05% 1.14% Allowance for loan losses to nonperforming loans 315.02% 260.75% Nonperforming assets to total assets 0.28% 0.55% </TABLE> Page 13
Nonperforming assets increased to $3,254,000, or 0.55% of total assets, at September 30, 2001 from $1,607,000, or 0.28% of total assets, at December 31, 2000. The increase was predominately due to one credit of $977,000. The collateral securing the credit was repossessed during the first quarter of this year. Additionally, one credit totaling $543,000 was designated as nonperforming during the third quarter. We expect the above mentioned credits to present modest loss exposure. Potential problems loans are those that display a high degree of credit risk for a variety of reasons including adverse borrower trends. They may or may not be performing at an acceptable level. The increase of $1.68 million in potential problem loans from December 31, 2000 to September 30, 2001 is primarily due to one loan on a strip mall. The loan is adequately collateralized and is, at this time, performing at an acceptable level. However, we felt that adverse borrower trends warranted reporting this loan as a potential problem loan. 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 in our loan portfolio based on our assessment of various factors 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. The following table summarizes the changes in our allowance for loan losses: <TABLE> <CAPTION> Nine Months Ended September 30, 2000 2001 ------------------------------------ (in thousands) <S> <C> <C> Allowance balance at beginning of period $ 4,264 $ 5,063 Provision for loan losses 585 807 Charge-offs Real estate - Commercial (3) - Agriculture (6) (59) Consumer (2) (11) ------------------------------------ Total charge-offs (11) (70) ------------------------------------ Recoveries Real estate 22 1 Commercial 28 - Agriculture 1 - Consumer - 1 ------------------------------------ Total recoveries 51 2 ------------------------------------ Net (charge-offs) recoveries 40 (68) ------------------------------------ Allowance balance at end of period $ 4,889 $ 5,802 ============= =========== Allowance for loan loss to loans 1.04% 1.14% ===== ===== </TABLE> Page 14
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 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, satisfy other financial commitments and fund operations. We generally maintain sufficient cash and short-term investments to meet short-term liquidity needs. At September 30, 2001, cash and cash equivalents totaled $26.5 million (4.5% 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 $2.2 million (.37% of total assets). At September 30, 2001, we maintained a combined credit facility with the FHLB of Seattle for Heritage Bank and Central Valley Bank of $110.4 million (of which $15.4 million was outstanding at that date). Capital Stockholders' equity at September 30, 2001 was $79.4 million compared with $83.0 million at December 31, 2000. During the period, we repurchased $6.7 million of Heritage Financial Corporation stock; declared three cash dividends totaling $2.4 million (9.5 cents per share, to shareholders of record on April 16, 2001, 10.0 cents per share to shareholders of record on July 16, 2001, and 10.5 cents per share to shareholders of record on October 15, 2001); realized year to date income of $4.8 million; recorded $248,000 in unrealized gains on securities available for sale, and had stock options of $383,000 exercised by our employees and directors. 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, 2001, our leverage ratio was 12.4%, compared with 14.0% at December 31, 2000. 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 14.8% and 15.8%, respectively, at September 30, 2001 compared with 16.0% and 17.1%, respectively, at December 31, 2000. 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, 2001. Page 15
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. During the first nine months of this year, the Federal Reserve moved to significantly lower short term interest rates. In our opinion, there has not been a material change in our interest rate risk exposure since our most recent year end at December 31, 2001. 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 16
PART II. OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS OF FORM 8-K a. There are no exhibits with this report. b. There were no 8-K filings for the quarter ended September 30, 2001. Page 17
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has caused this report to be signed on its behalf by the undersigned. HERITAGE FINANCIAL CORPORATION Date: November 8, 2001 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 18