Heritage Financial - 10-Q quarterly report FY

Heritage Financial Corporation is a bank holding company that was incorporated in the State of Washington in August 1997. We were organized for the purpose of acquiring all of the capital stock of Heritage Savings Bank upon our 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 Savings Bank and Central Valley Bank, N.A. Heritage Savings 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). Heritage Savings Bank conducts business from its main office in Olympia, Washington and its eleven branch offices located in Thurston, Pierce, and Mason Counties. Central Valley Bank, N.A. is a national bank whose deposits are insured by the FDIC under the Bank Insurance Fund (BIF). Central Valley Bank, N.A. 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 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. We also make residential construction loans, income property loans, and consumer loans.

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 with our December 31, 2001 audited consolidated financial statements and its accompanying notes 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, 2002 are not necessarily indicative of the results that may be expected for the year ended December 31, 2002. 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.

In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 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,

In August 2001, the FASB issued SFAS 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 SFAS No. 144 supersedes SFAS 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. SFAS No. 144 also supersedes the accounting and reporting provisions of Accounting Principles Board (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 distribution to owners) or is classified as held for sale. This statement was adopted January 1, 2002 and did not have a material effect on the results of our operations or financial position.

In April 2002, the Financial Accounting Standards Board issued Financial Accounting Standard (FAS) No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This Statement rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. This Statement also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers. This Statement amends FASB Statement No. 13, Accounting for Leases, to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The provisions of this Statement related to Statement 13 are effective for transactions occurring after May 15, 2002. All other provisions of this Statement are effective for financial statements issued on or after May 15, 2002. Management has not yet determined the impact of adopting this Statement.

In June 2002, the Financial Accounting Standards Board issued Financial Accounting Standard (FAS) No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). The provisions of this Statement are effective for exit and disposal activities that are initiated after December 31, 2002. Management has not yet determined the impact of adopting this Statement.

The following table illustrates the reconciliation of weighted average shares used for earnings per share for the noted periods.

As of September 30, 2002, there were no anti-dilutive shares. As of September 30, 2001, options to purchase 69,600 shares were anti-dilutive and excluded from the calculation of diluted earnings per share.

On September 23, 2002, we announced a quarterly cash dividend of 12.5 cents per share payable on October 29, 2002 to stockholders of record on October 15, 2002.

In July 2001, the 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 by 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. Rather, goodwill is reviewed for impairment, 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, were adopted by us on January 1, 2002. Nonamortized goodwill in the amount of $6,640,000 was subject to the transition provisions of SFAS Nos. 141 and 142. Other than the discontinuation of monthly goodwill amortization, the adoption of this statement did not have a material impact on the results of our operations or financial position.

The following table illustrates the impact of adopting SFAS No. 141 and 142 for the applicable periods.

In 1994, we began implementation of a growth strategy, which was 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 enhance revenue in November 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 to 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 half of 2001. We began to realize the benefits in the form of revenue enhancements and reduced expenses during the second half of 2001 as well as subsequent periods.

Total assets decreased $4.3 million or 0.7% to $587.5 million at September 30, 2002 from the September 30, 2001 balance of $591.8 million. Net loans (loans receivable less allowance for loan losses and excluding loans held for sale) decreased $26.7 million or 5.4% to $468.3 million at September 30, 2002 from $495.0 million at September 30, 2001. The decline in loans is a result of the national and local economic weaknesses as well as the low interest rates causing a significant volume of refinancing by customers. Commercial loans continue to be the largest segment of the loan portfolio at 50.8% and 52.8% of all loans as of September 30, 2002 and December 31, 2001, respectively. Deposits increased $13.1 million or 2.7% to $502.7 million at September 30, 2002 from $489.6 million at September 30, 2001. The growth in deposits has continued to occur in transaction and savings accounts, while certificates of deposit continued to decline.

In addition to 100,000 shares repurchased in April 1999, we started the first of five 10% stock repurchase programs in October 1999. As of September 30, 2002 we repurchased a total of 4,257,683 shares, or 39.2% of the total outstanding at March 1999 at an average price of $10.14 per share. During the quarter ended September 30, 2002, we repurchased 294,544 shares at an average price of $16.10. We began its fifth, and current, 10% repurchase program in June 2002 with a target to repurchase approximately 750,000 shares over a period of eighteen months. Through September 30, 2002, we repurchased 405,392 shares or 54.1% of the fifth program at an average price of $16.04.

Net income for the third quarter ended September 30, 2002 was $0.335 per diluted share compared with $0.261 per diluted share for the quarter ended September 30, 2001, for an increase of 28.4%. Actual earnings for the third quarter ended September 30, 2002 were $2,460,000 compared to $2,079,000 for the third quarter in 2001, an increase of 18.3%. The third quarter earnings reflect the elimination of goodwill amortization due to the adoption of Financial Accounting Standard (FAS) 142 effective January 1, 2002, which requires the nonamortization approach for goodwill. The charge to earnings for amortization of goodwill for the third quarter of 2001 was $144,000. Excluding the charge for amortization, net income in the third quarter of 2001 would have been $2,223,000 and earnings per diluted share in the third quarter of 2001 would have been $0.279, resulting in an increase in diluted earnings per share this year of 20.1% over the prior year’s third quarter.

Net income for the nine months ended September 30, 2002 was $7,011,000 or $0.932 per diluted share compared with $4,752,000 or $0.577 per diluted share for the same period in 2001 for an increase in earnings per share of 61.5%. The nine month period ended September 30, 2001 included $433,000 for amortization of goodwill and net after tax nonrecurring charges of $389,000 for Vision 2001. Excluding these items, net income for the nine months ended September 30, 2001 would have been $5,574,000, or $0.677 per diluted share, for an increase this year in earnings per diluted share of 37.7%.

Net interest income for the three months ended September 30, 2002 increased 12.3% to $7,609,000 from $6,778,000 for the same quarter in 2001. Net interest income before provision for loan loss for the nine months ended September 30, 2002 increased 16.0% to $22,582,000 from $19,472,000 for the nine months ended September 30, 2001. The net interest margin (net interest income divided by average interest earning assets) increased to 5.68% for the three months ended September 30, 2002 from 5.04% for the same quarter last year. For the nine months ended September 30, 2002, the net interest margin increased to 5.52% from 4.88% for the nine months ended September 30, 2001.

Interest rates remained low in the third quarter of 2002. We have worked to keep deposit pricing in line with market rates. Interest income declined $1,205,000 or 10.7% versus the same quarter last year and interest expense declined $2,036,000 or 45.9% during this same period. Interest income declined $3,831,000 or 11.1% versus the same nine month period last year and interest expense declined $6,941,000 or 46.6% during this same period. The large decrease in interest expense resulted primarily from the favorable repricing of maturing certificates of deposit and the shifting of certificates of deposits into lower costing transaction accounts. Certificates of deposit averaged $216.8 million with an average cost of 2.95% for the quarter ended September 30, 2002 compared to $244.1 million with an average cost of 4.94% for the same period in 2001. Certificates of deposit averaged $228.5 million with an average cost of 3.13% for the nine months ended September 30, 2002 compared to $246.7 million with an average cost of 5.55% for the same period in 2001. Our overall cost of funds decreased to 2.14% for the quarter ended September 30, 2002 from 3.91% for the quarter ended September 30, 2001. Our cost of funds decreased to 2.31% for the nine months ended September 30, 2002 from 4.43% for the same period last year.

For the nine months ended September 30, 2002, the loan loss provision expense was $1,340,000 compared with $807,000 for the nine months ended September 30, 2001. The quarterly provision for loan losses was $495,000 for the current quarter up from $290,000 for the same quarter in 2001. We believe that the increases were necessary to ensure that we maintain an adequate allowance for loan losses given the increased risk in our loan portfolio resulting from our emphasis on commercial lending, and our agricultural portfolio at Central Valley Bank.

Noninterest income for the quarter ended September 30, 2002 increased 2.8% to $1,552,000 compared with $1,509,000 for the same quarter in 2001. Noninterest income increased 3.1% to $4,428,000 for the nine months ended September 30, 2002 compared with $4,296,000 for the same period in 2001. Noninterest income for the nine months ended September 30, 2001 included the 2001 first quarter sale of our ownership interest in Transalliance Corporation, a debit and credit card processor, which resulted in a 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. The increase in noninterest income for the quarter and the nine months ended September 30, 2002 over the previous year’s results was primarily a result of the improved service charges on deposits and improved merchant visa income.

Noninterest expense increased by 3.3% to $4,944,000 for the quarter ended September 30, 2002 compared to $4,786,000 for the quarter ended September 30, 2001. Noninterest expense decreased 3.2% to $15,077,000 for the nine months ended September 30, 2002 compared to $15,578,000 for the nine months ended September 30, 2001. Excluding Vision 2001 expenses of $589,000 and goodwill amortization of $433,000 incurred through September 30, 2001, noninterest expense for the

Since initiating our expansion activities in 1994, we have supplemented our traditional mortgage loan products by increasing our emphasis on commercial loans. As indicated in the table below, total loans decreased to $482.3 million at September 30, 2002 from $498.7 million at December 31, 2001.

The following table describes our nonperforming assets for the dates indicated.

Nonperforming assets increased to $4,147,000, or 0.71% of total assets, at September 30, 2002 from $3,015,000, or 0.49% of total assets at December 31, 2001. Total nonperforming assets at September 30, 2002 are centered primarily in three credits together totaling approximately $3,406,000. One of these credits, in the amount of $857,000, was paid off with interest subsequent to September 30, 2002. Management anticipates further reductions in nonperforming assets during the fourth quarter and believes that while some losses could occur the Company has adequately reserved for any potential loss.

Management maintains an allowance for loan losses to absorb estimated credit losses associated with the loan and lease portfolio, including all binding commitments to lend. We determine an adequate allowance through our ongoing quarterly loan quality assessments.

We assess the estimated credit losses inherent in our non-classified loan portfolio by considering a number of elements including:

We calculate an adequate allowance for the non-classified portion of our loan portfolio based on an appropriate percentage risk factor that is calculated based on the above-noted elements and trends. We add specific provisions for each classified loan after a careful analysis of that loan’s credit and collateral factors. Our analysis of an adequate allowance combines the provisions made for both our non-classified loans and the specific provisions made for each classified loan.

We determine our provision expense for the next quarter by applying the same percentage risk factor applied to the non-classified loan portfolio to our expected loan growth. We determine our monthly provision expense by dividing our estimate of provision expense for the quarter by three.

Our historical loan loss experience remains low, even though we experienced higher loan losses in the last quarter of 2001 and the first quarter of this year than in prior periods. We believe that it is appropriate to maintain a higher allowance for estimated credit losses, particularly with respect to our commercial loan portfolio, than our historical loan loss experience indicates.

We have increased our allowance for loan losses over the past several years during a period of strong loan growth and changes in our loan portfolio composition. Our commercial loan portfolio has grown as a percentage of the total loan portfolio, while other less risky categories, such as the residential mortgage portfolio, have declined as a percentage of the total portfolio. We expect to continue to increase our allowance for loan losses because of the higher risk associated with commercial lending as experienced by the commercial banking industry.

While we believe we use the best information available to determine the allowance for loan losses, net income could be significantly affected if circumstances differ substantially from the assumptions used in determining the allowance or unforeseen market conditions arise that cause adjustments to the allowance for loan losses.

The following table summarizes the changes in our allowance for loan losses:

(1) Includes loans held for sale

While pursuing our growth strategy, we continue to employ appropriate underwriting and sound monitoring procedures to maintain asset quality. The allowance for loan losses during the nine months ended September 30, 2002 increased by $1,058,000 to $6.8 million from $5.75 million at December 31, 2001. The growth in the allowance was due to the $1,340,000 provision, which was partially offset by $282,000 in net charge offs during the nine month period. While management cannot predict with any certainty the future level of charge offs, the continuation of a weak economy may result in further charge offs.

Our primary sources of funds are customer deposits, public funds, loan repayments, loan sales, interest earned on and proceeds from 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, 2002, cash and cash equivalents totaled $38.0 million, and investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $231,000, or 0.04% of total assets. At September 30, 2002, our banks maintained a credit facility with the FHLB of Seattle for $111.2 million, with total borrowings of $5.0 million as of September 30, 2002.

Stockholders’ equity at September 30, 2002 was $73.2 million compared with $78.5 million at December 31, 2001. During the period, we repurchased $10.6 million of Heritage Financial Corporation stock, declared dividends of $2.6 million (11.5 cents per share to shareholders of record on April 15, 2002, 12 cents per share to shareholders of record on July 15, 2002, and 12.5 cents per share to shareholders of record on October 15, 2002), realized income of $7.0 million, recorded $306,000 in unrealized gains on securities available for sale, and realized the effects of exercising stock options totaling $456,000.

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, 2002, our leverage ratio was 11.5% compared with 12.2% at December 31, 2001. 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 risk based capital ratios were 13.9% and 15.1%, respectively, at September 30, 2002 compared with 14.7% and 15.9%, respectively, at December 31, 2001.

During 1992, 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 based capital ratio of at least 6%, a total risk based 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, 2002.

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 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.

(a)  Evaluation of disclosure controls and procedures. We maintain controls and procedures designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934 are recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. Based upon their evaluation of those controls and procedures performed within 90 days of the filing date of this report, the chief executive and chief financial officers of the Company concluded that the Company’s disclosure controls and procedures were adequate.

(b)  Changes in internal controls. We made no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of the evaluation of those controls by the Chief Executive and Chief Financial officers.

On August 12, 2002, the Company filed a Form 8-K to satisfy the filing requirement mandated by Section 906 of the Sarbanes-Oxley Act of 2002, which provided for the Certification of Principal Executive Officer and Principal Financial Officer of the Form 10-Q.

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 duly authorized officials.

I, Donald V. Rhodes, certify that:

1.  I have reviewed this quarterly report on Form 10-Q of Heritage Financial Corporation;

2.  Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.  Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.  The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a)  designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b)  evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c)  presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5.  The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a)  all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b)  any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.  The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.

I, Edward D. Cameron, certify that:

1.  I have reviewed this quarterly report on Form 10-Q of Heritage Financial Corporation;

2.  Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.  Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.  The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a)  designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b)  evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c)  presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a)  all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b)  any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6.  The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.