SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 1998 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 May 6, 1998 there were outstanding 9,763,290 common shares, with no par value, of the registrant. Page 1
HERITAGE FINANCIAL CORPORATION FORM 10-Q INDEX <TABLE> <CAPTION> PART I. Financial Information Page - -------------------------------------------------------------------------------------- <S> <C> <C> Item 1. Condensed Financial Statements (Unaudited) Consolidated Statements of Income for the Three and 3 Nine Months Ended March 31, 1997 and 1998 Consolidated Statements of Financial Condition 4 As of June 30, 1997 and March 31, 1998 Consolidated Statement of Stockholders' Equity 5 for the Nine Months Ended March 31, 1998 Consolidated Statements of Cash Flows for the 6 Nine Months Ended March 31, 1997 and 1998 Notes to Condensed Financial Statements 7 Item 2. Management's Discussion and Analysis of 10 Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures About Market 17 Risk PART II. Other Information Item 2. Change in Securities and Use of Proceeds 18 Item 6. Exhibits and Reports on Form 8-K 19 Signatures 19 </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 March 31, March 31, --------------------------------------------------------------- 1997 1998 1997 1998 ------ ----- ------ ------ <S> <C> <C> <C> <C> INTEREST INCOME: Loans $4,225 4,925 12,180 14,525 Mortgage backed securities 115 100 355 308 Investment securities and FHLB dividends 151 209 596 505 Interest bearing deposits 101 888 511 1,214 ------ ----- ------ ------ Total interest income 4,592 6,122 13,642 16,552 INTEREST EXPENSE: Deposits 2,199 2,510 6,715 7,478 Borrowed funds - - - 8 ------ ----- ------ ------ Total interest expense 2,199 2,510 6,715 7,486 ------ ----- ------ ------ Net interest income 2,393 3,612 6,927 9,066 PROVISION FOR LOAN LOSSES - 30 - 90 ------ ----- ------ ------ Net interest income after provision for loan 2,393 3,582 6,927 8,976 loss NONINTEREST INCOME: Gains on sales of loans 385 717 1,498 1,819 Commissions on sales of annuities and securities 77 32 168 106 Service charges on deposits 113 143 343 397 Rental income 50 52 159 156 Gains on sale of premises - - - 36 Other income 101 103 271 306 ------ ----- ------ ------ Total noninterest income 726 1,047 2,439 2,820 NONINTEREST EXPENSE: Salaries and employee benefits 1,361 1,507 4,034 4,470 Building occupancy 432 440 1,206 1,297 FDIC premiums and special assessment - 34 1,229 98 Data processing 143 170 401 494 Marketing 57 93 155 275 Office supplies and printing 56 60 180 188 Other 351 545 999 1,247 ------ ----- ------ ------ Total noninterest expense 2,400 2,849 8,204 8,069 ------ ----- ------ ------ Income before federal income tax (benefit) 719 1,780 1,162 3,727 Federal income tax (benefit) 245 621 (540) 1,312 ------ ----- ------ ------ Net income $ 474 1,159 1,702 2,415 ====== ===== ====== ====== Earnings per share: Basic $ 0.05 0.12 0.18 0.26 Diluted $ 0.05 0.11 0.18 0.25 </TABLE> See Notes to Condensed Financial Statements Page 3
HERITAGE FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (Dollars in Thousands) (Unaudited) <TABLE> <CAPTION> JUNE 30, MARCH 31, 1997 1998 ----------------------------------- <S> <C> <C> ASSETS Cash on hand and in banks $ 7,412 6,893 Interest earning deposits 175 59,046 Investment securities held to maturity 8,506 18,542 Mortgage backed securities held to maturity 5,159 4,344 Loans held for sale 6,323 8,150 Loans receivable 201,870 213,224 Less: Allowance for loan losses (2,752) (2,842) ----------------------------------- Loans, net 199,118 210,382 Real Estate Owned - 79 Premises and equipment, net 12,202 11,659 Federal Home Loan Bank stock 1,511 1,602 Accrued interest receivable 1,380 1,773 Prepaid expenses and other assets 378 336 ----------------------------------- $242,164 322,806 =================================== LIABILITIES AND STOCKHOLDERS' EQUITY Deposits 209,781 225,619 Advances from Federal Home Loan Bank 890 - Advance payments by borrowers for taxes and insurance 473 752 Accrued expenses and other liabilities 2,605 2,777 Deferred Federal income taxes 701 701 ----------------------------------- 214,450 229,849 Stockholders' equity: Preferred stock, $1 par value per share, 5,000,000 shares authorized; none outstanding - - Common stock, $1 par value per share,10,000,000 shares authorized; 1,809,616 shares outstanding 1,810 - Preferred stock, no par value per share, 2,500,000 shares authorized; none outstanding - - Common stock, no par value per share,15,000,000 shares authorized; 9,755,067 shares outstanding - 70,398 Additional paid-in capital 4,103 - Unallocated common stock held by ESOP - (1,315) Retained earnings, substantially restricted 21,801 23,874 ----------------------------------- Total stockholders' equity 27,714 92,957 Commitments and contingencies ----------------------------------- $242,164 322,806 =================================== </TABLE> See Notes to Condensed Financial Statements Page 4
HERITAGE FINANCIAL CORPORATION CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY Nine Months Ended March 31, 1998 (Dollars in Thousands) (Unaudited) <TABLE> <CAPTION> UNALLOCATED ADDITIONAL COMMON TOTAL COMMON PAID IN STOCK HELD BY RETAINED STOCKHOLDERS' STOCK CAPITAL ESOP EARNINGS EQUITY ------------------------------------------------------------------------------------------ <S> <C> <C> <C> <C> <C> Balance at June 30, 1997 $ 1,810 4,103 - 21,801 27,714 Offering proceeds 64,352 - (1,322) - 63,030 ESOP loan repayments - - 7 - 7 Conversion transaction 4,223 (4,103) - - 120 Exercise of stock options 13 - - - 13 Net income - - - 2,415 2,415 Cash dividend declared - - - (342) (342) ------------------------------------------------------------------------------------------ Balance at March 31, 1998 $70,398 - (1,315) 23,874 92,957 ========================================================================================== </TABLE> See Notes to Condensed Financial Statements Page 5
HERITAGE FINANCIAL CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (Dollars in Thousands) (Unaudited) <TABLE> <CAPTION> Nine Months Ended March 31, -------------------- 1997 1998 ---- ---- <S> <C> <C> Cash flows from operating activities: Net income $ 1,702 2,415 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 704 756 Deferred loan fees, net of amortization 5 (124) Provision for loan losses (2) 90 Net increase(decrease) in loans held for sale 1,847 (1,827) Deferred Federal income tax expense (benefit) (960) - Federal Home Loan Bank stock dividends (83) (91) Net change in accrued interest receivable, prepaid expenses and other assets, and accrued expenses and other liabilities 1,356 (514) -------------------- Net cash provided by operating activities 4,569 705 -------------------- Cash flows from investing activities: Loans originated, net of principal payments and loan sales (29,099) (11,309) Principal payments of mortgage backed securities 611 822 Proceeds from maturities of investment securities held to maturity 9,160 5,170 Purchase of investment securities held to maturity (2,360) (15,194) Purchase of premises and equipment (1,539) (231) -------------------- Net cash used in investing activities (23,227) (20,742) -------------------- Cash flows from financing activities: Net increase in deposits 8,926 15,957 Net decrease in FHLB advances - (890) Net increase in advance payment by borrowers for taxes and insurance 298 279 Cash dividends paid (228) - Proceeds from exercise of stock options 28 13 Proceeds received for stock conversion - 63,030 -------------------- Net cash provided by financing activities 9,024 78,389 -------------------- Net increase(decrease) in cash and cash equivalents (9,634) 58,352 Cash and cash equivalents at beginning of period 18,082 7,587 -------------------- Cash and cash equivalents at end of period $ 8,448 65,939 ==================== Supplemental disclosures of cash flow information: Cash payments for: Interest expense $ 6,702 7,513 Federal income taxes 420 1,220 </TABLE> See Notes to Condensed Financial Statements Page 6
HERITAGE FINANCIAL CORPORATION NOTES TO CONDENSED FINANCIAL STATEMENTS Nine Months Ended March 31, 1998 and 1997 (Unaudited) NOTE 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION (a.) Description of Business Heritage Financial Corporation (the "Company") was recently organized as the holding company for the Heritage Savings Bank (the "Bank"). Effective January 8, 1998, the Company closed its second step conversion and stock offering which resulted in $66.1 million in gross proceeds. Effective January 9, 1998, the Company's common stock began to trade on the Nasdaq National Market under the symbol "HFWA". Prior to January 8, 1998 the Bank was majority-owned by Heritage Financial Corporation, M.H.C. (MHC), a Washington state mutual holding company, whose securities were not registered pursuant to the Securities Exchange Act of 1934, nor publicly traded. Effective January 8, 1998, the MHC was merged into the Bank. (b.) Basis of Presentation The financial statements shown herein are for the Bank only through December 31, 1997 and for the consolidated Company thereafter. 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 the Bank's June 30, 1997 audited consolidated financial statements and notes thereto included in the Company's recent Registration Statement on Form S-1 filed with the Securities and Exchange Commission under file number 333-35573. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended March 31, 1998 are not necessarily indicative of the results that may be expected for the year ended June 30, 1998. In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the dates of the balance sheets, contingent assets and liabilities and revenues and expenses for the periods presented. NOTE 2. STOCKHOLDERS' EQUITY (a.) Stock Offering and Conversion Effective January 8, 1998, the Company sold 6.6 million shares of its common stock at a subscription price of $10 per share to the Bank's customers, its existing stockholders and the general public. Of the 1.8 million shares of Heritage Savings Bank common stock outstanding at December 31, 1997, 1.2 million shares owned by Heritage Financial Corporation, M.H.C. (the "Mutual Holding Company") were canceled on January 8, 1998 and the Page 7
Mutual Holding Company was merged into the Bank. The remaining 0.6 million shares of the Bank's common stock owned by its stockholders were converted into 3.1 million shares of the Company's common stock outstanding. (b.) Earnings per Share The Company adopted the Financial Accounting Standards Board ("FASB") Statement No. 128, "Earnings Per Share" for the period ending December 31, 1997. This statement establishes standards for computing and presenting earnings per share ("EPS"). It replaced the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS on the face of the income statement for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. Basic earnings per share is computed by dividing income available to common stockholders (the numerator) by the weighted average number of common shares outstanding (the denominator) during the period. Shares issued during the period and shares reacquired during the period are weighted for the portion of the period that they were outstanding. Diluted earnings per share is similar to the computation of basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive options outstanding had been exercised. The following tables illustrate the reconciliation of weighted average shares used for earnings per share for the applicable periods. <TABLE> <CAPTION> Three months ended March 31, 1997 1998 ------------------------ <S> <C> <C> Basic: Weighted average shares 1,808,299 9,719,506 Effect of stock conversion 7,502,994 - ------------------------ Weighted average shares outstanding 9,311,293 9,719,506 ======================== Diluted: Basic weighted average share outstanding 9,311,293 9,719,506 Incremental shares from stock options 79,262 424,839 ------------------------ Weighted average shares outstanding 9,390,555 10,144,345 ======================== </TABLE> <TABLE> <CAPTION> Nine months ended March 31, 1997 1998 ------------------------ <S> <C> <C> Basic: Weighted average shares 1,807,543 9,449,932 Effect of stock conversion 7,499,859 - ------------------------ Weighted average shares outstanding 9,307,403 9,449,932 ======================== </TABLE> Page 8
<TABLE> <S> <C> <C> Diluted: Basic weighted average share outstanding 9,307,403 9,449,932 Incremental shares from stock options 82,058 204,636 ------------------------ Weighted average shares outstanding 9,389,461 9,654,568 ======================== </TABLE> Earnings per share information for periods prior to January 8, 1998 is based on the historical weighted average common shares outstanding for the Bank during the applicable period multiplied by the exchange ratio utilized in the stock conversion (5.1492). On January 8, 1998, the former stockholders of the Bank received 5.1492 shares of the Company's common stock for each share of the Bank's common stock exchanged. c. Cash Dividend Declared On March 24, 1998, the Company announced a quarterly cash dividend of 3.5 cents per share payable on April 15, 1998 to shareholders of record on April 6, 1998. NOTE 3. FEDERAL INCOME TAXES The Bank recorded a Federal income tax benefit of $540,000 for the nine months period ended March 31, 1997 as a result of the reversal of $938,000 deferred tax liability related to the potential recapture of the pre-1988 additions to the tax bad debt reserve which could have been triggered by the Mutual Holding Company reorganization in January 1994. Based on subsequent legislation in August 1996, the Bank reversed the $938,000 deferred tax liability as a reduction of Federal income tax expense during the quarter ended September 30, 1996. NOTE 4. SUBSEQUENT EVENT - ACQUISITION On April 6, 1998, the Company announced an agreement to acquire all of the outstanding stock of North Pacific Bancorporation whose wholly owned subsidiary is North Pacific Bank. Based on a formula which includes the earnings of North Pacific Bank from January 1, 1998 through the consummation date less certain adjustments, the Company expects to pay approximately $18 million in cash to acquire all of the stock of North Pacific Bancorporation from its sole stockholder. At a future date, the Company intends to merge the operations of North Pacific Bank with Heritage Bank. This transaction will be accounted for using the purchase accounting method. North Pacific Bank operates two banking offices in Tacoma with assets of $74.7 million at March 31, 1998. The agreement, which was approved by the respective Boards of Directors of the parties and the sole stockholder of North Pacific Bancorporation, is subject to a number of conditions, including the approval of various regulatory agencies. The parties anticipate closing the stock purchase transaction by June 30, 1998. 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 the Company. The information contained in this section should be read in conjunction with the Condensed Financial Statements and the accompanying Notes thereto and the June 30, 1997 audited consolidated financial statements and notes thereto included in the Company's recent Registration Statement on Form S-1 filed with the Securities and Exchange Commission under file number 333-35573 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 THE COMPANY'S FINANCIAL RESULTS ARE INCLUDED IN FILINGS BY THE COMPANY WITH THE SECURITIES AND EXCHANGE COMMISSION. OVERVIEW Beginning in 1994, the Company began to implement a growth strategy which is intended to broaden its 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, the Company closed its second step conversion and stock offering which resulted in $66.1 million in gross proceeds. Thereafter, the Company's common stock began to trade on the Nasdaq National Market under the symbol "HFWA". The Company intends to continue to fund its assets primarily with retail deposits, although FHLB advances may be used as a supplemental source of funds, and it believes that the capital raised in the recent stock offering will enhance its ability to continue implementing its growth strategy. FINANCIAL CONDITION DATA The Company's total assets at March 31, 1998 were $322.8 million, a 33% increase from June 30, 1997. Of the $80.6 million increase in total assets from June 30, 1997, $63.0 million were funds related to the recent stock offering which closed January 8, Page 10
1998. Net loans outstanding and loans held for sale totaled $218.5 million at March 31, 1998, an increase of 12% from March 31, 1997 and a 6% increase from June 30, 1997. The Company experienced substantial growth in commercial loans during the nine months ended March 31, 1998. Commercial loans increased to $51.8 million at March 31, 1998, compared with $39.4 million at June 30, 1997, an increase of 31%. Deposits were $225.6 million at March 31, 1998, an increase of 13% from March 31, 1997 and a 8% increase from June 30, 1997. The Company's allowance for loan losses at March 31, 1998 was $2.8 million, or 1.28% of outstanding loans. Nonperforming assets at March 31, 1998 amounted to $373,000, or 0.12% of total assets. There were no loan charge-offs or recoveries during the nine months ended March 31, 1998. EARNINGS SUMMARY Net income for the third quarter ended March 31, 1998 was $1,159,000, or $0.11 per diluted share, compared to $474,000, or $0.05 per diluted share, for the same period in 1997, an increase of 145%. Earnings per share for the nine months ended March 31, 1997 were computed as set forth in Note 2(b) in the Notes to Condensed Financial Statements. The increase in net income was primarily due to an $88 million increase in the average balance of earning assets, a widening of the net interest margin and a substantial increase in mortgage banking activity and related income. The majority of the increase in earning assets ($63 million) and the widening of the net interest margin was attributable to the large influx of equity capital resulting from the Company's recently completed stock offering. Net income for the nine months ended March 31, 1998 was $2.4 million, or $0.25 per diluted share, compared with $1.7 million, or $0.18 per diluted share, for the same period in 1997. This represents a 42% increase period to period. During the quarter ended September 30, 1996, based on federal legislation, the Company accrued $1.1 million for a one-time assessment by the FDIC to recapitalize the SAIF deposit insurance fund. The Company also reversed a $938,000 deferred tax liability related to the potential recapture of the pre- 1988 additions to the tax bad debt reserve. Excluding the impact of these two nonrecurring items, net income for the nine months ended March 31, 1997 would have been $1.5 million, or $0.16 per diluted share. On a comparable fully taxed basis, net income for the nine months ended March 31, 1998, increased by $0.9 million, or 60%, compared with the first nine months of fiscal 1997. The increase in net income on such a comparable basis was primarily attributable to increases in net interest income and mortgage banking income partially offset by an increase in noninterest expense. On April 6, 1998, the Company announced an agreement to acquire all of the outstanding stock of North Pacific Bancorporation whose wholly owned subsidiary is North Pacific Bank. Based on a formula which includes the earnings of North Pacific Bank from January 1, 1998 through the consummation date less certain adjustments, the Company expects to pay approximately $18 million in cash to acquire all of the stock of North Pacific Bancorporation from its sole stockholder. At a future date, the Page 11
Company intends to merge the operations of North Pacific Bank with Heritage Bank. This transaction will be accounted for using the purchase accounting method. North Pacific Bank operates two banking offices in Tacoma with assets of $74.7 million at March 31, 1998. The agreement, which was approved by the respective Boards of Directors of the parties and the sole stockholder of North Pacific Bancorporation, is subject to a number of conditions, including the approval of various regulatory agencies. The parties anticipate closing the stock purchase transaction by June 30, 1998. NET INTEREST INCOME Net interest income for the three months ended March 31, 1998 increased 49% to $3.6 million from $2.4 million for the comparable 1997 quarter. For the nine months ended March 31, 1998, net interest income increased to $9.1 million, a 31% increase from $6.9 million for the same period in 1997. The increase in net interest income during the nine months ended March 31, 1998 was largely due to average interest earning assets increasing more rapidly than average interest bearing liabilities coupled with the substantial increase in stockholders' equity resulting from the recent stock offering. For the nine month period ended March 31, 1998 compared to the same period in 1997, average balance of interest earning assets increased $47 million, while the average balance of interest bearing liabilities increased $24 million. Net interest margin (net interest income divided by average interest earning assets) increased to 4.82% in the third quarter of fiscal 1998 from 4.53% in the third quarter of fiscal 1997. The increase in net interest margin was primarily the result of increased capital from the stock offering. While net interest margin widened, net interest spread declined to 3.57% from 4.10%. The average yield of earning assets declined to 8.17% for third quarter 1998 from 8.70% for third quarter fiscal 1997 due to investment of the stock offering net proceeds in lower yielding assets as management seeks to deploy the funds in higher yielding loans. For the nine months ended March 31, 1998, net interest margin increased to 4.72% from 4.42% for the same period in 1997. The average yield of interest earning assets decreased to 8.63% for the 1998 fiscal period from 8.71% for the 1997 fiscal period due to the shift in the mix of earning assets resulting from the investment of the stock offering net proceeds. In comparison, the average cost of interest bearing liabilities decreased to 4.68% for the 1998 fiscal period from 4.73% for the 1997 fiscal period. NONINTEREST INCOME Noninterest income for the three months ended March 31, 1998 increased $320,000, or 44%, compared with the 1997 comparable period. Gains on sales of loans increased $331,000, or 86%, for the three months ended March 31, 1998, as a result of the volume of mortgage loans sold increasing 72% ($31.8 million in the 1998 quarter compared to $18.5 million for the 1997 comparable quarter) while the average gain (expressed as a percentage of the volume of mortgage loans sold) increased to 2.26% Page 12
in the quarter ended March 31, 1998 compared to 2.09% in the comparable 1997 quarter. Service charges on deposits for the third quarter of fiscal 1998 increased $30,000 or 27%, which was offset by a $45,000 decline in commissions on sales of annuities and securities. For the nine months ended March 31, 1998, noninterest income increased $381,000, or 16%, compared to the same period in 1997. Gains on sales of loans increased $321,000, or 21%, for the nine months ended March 31, 1998 due to increased volume of mortgage loans sold ($77.0 million for the nine months ended March 31, 1998 compared to $64.1 million for the same period in 1997). Service charges on deposits increased $54,000, or 16%, for the nine months ended March 31, 1998 due to growth in business and personal checking accounts. NONINTEREST EXPENSE Noninterest expense for the three months ended March 31, 1998 increased $447,000, or 19%, compared with the same period in 1997. Excluding the impact of the $1.1 million one-time assessment by the FDIC to recapitalize the SAIF deposit insurance fund during the nine months ended March 31, 1997, noninterest expense for the nine months ended March 31, 1998 increased $954,000, or 13%, compared with the same period in 1997. The increases are primarily due to the expenses associated with the expansion of Heritage Bank into Pierce County and an increase in mortgage commissions due to increased volume of mortgage loan originations. Total noninterest expense was 61.15% and 67.89% of total revenues (the sum of net interest income plus noninterest income) for the third quarter and the nine months ended March 31, 1998, respectively, and 76.98% and 75.97% for the same periods in 1997, respectively. Increases in noninterest expenses are centered in compensation, occupancy, data processing, marketing and other expenses. INCOME TAXES Provision for federal income taxes was $1.3 million for the nine months ended March 31, 1998, compared to a federal income tax benefit of $540,000 for the same period in 1997. The federal income tax benefit for the 1997 period reflects the reversal of the $938,000 deferred tax liability mentioned in Note 3 of the Notes to Condensed Financial Statements. LENDING ACTIVITIES Since initiating its expansion activities in 1994, the Company has supplemented its traditional mortgage loan products with an increased emphasis on variable interest rate commercial loans. As indicated in the table below, total loans increased to $221.4 million at March 31, 1998 from $208.2 million at June 30, 1997. At March 31, 1998, commercial loans increased to $51.8 million, or 23.38% of total loans, from $39.4 million, or 18.95% of total loans, at June 30, 1997. <TABLE> <CAPTION> (in thousands) AT JUNE 30, % OF AT MARCH 31, % OF 1997 TOTAL 1998 TOTAL --------------------------------------------------- <S> <C> <C> <C> <C> </TABLE> Page 13
<TABLE> <S> <C> <C> <C> <C> Commercial $ 39,445 18.95% $ 51,762 23.38% Real estate mortgages One-to-four family residential 103,439 49.68 101,254 45.74 Five or more family and commercial properties 51,209 24.60 52,404 23.67 ----------------------------------------------- Total real estate mortgages 154,648 74.28 153,658 69.41 Real estate construction One-to-four family residential 12,683 6.09 13,777 6.22 Five or more family and commercial properties 1,029 0.50 1,565 0.71 ----------------------------------------------- Total real estate construction 13,712 6.59 15,342 6.93 Consumer 1,467 0.70 1,816 0.82 ----------------------------------------------- Gross loans 209,272 100.52% 222,578 100.54% Less: deferred loan fees (1,079) (0.52) (1,204) (0.54) ----------------------------------------------- Total loans $208,193 100.00% $221,374 100.00% =============================================== </TABLE> NONPERFORMING ASSETS The following table sets forth the amount of the Bank's nonperforming assets at the dates indicated <TABLE> <CAPTION> At June 30, At March 31, 1997 1998 ----------------------- (Dollars in thousands) <S> <C> <C> Nonaccrual loans $ 133 294 Restructured loans - - ----------------------- Total nonperforming loans 133 294 Real estate owned - 79 ----------------------- Total nonperforming assets $ 133 373 ======================= Accruing loans past due 90 days or more $ - - Potential problem loans 68 47 Allowance for loan losses 2,752 2,842 Nonperforming loans to loans 0.06% 0.17% Allowance for loan losses to loans 1.32% 1.28% Allowance for loan losses to nonperforming loans 2,069.17% 966.67% Nonperforming assets to total assets 0.05% 0.12% </TABLE> Nonperforming loans increased to $294,000, or 0.17% of total loans, at March 31, 1998 from $133,000, or 0.06% of total loans, at June 30, 1997. At both dates shown in the table above, the nonaccrual loans were comprised of single family mortgages. During the nine months ended March 31, 1998, the Company foreclosed on a $79,000 residential mortgage loan which was transferred to real estate owned in the third quarter 1998. ANALYSIS OF ALLOWANCE FOR LOAN LOSSES Page 14
The allowance for loan losses is maintained at a level considered adequate by management to provide for reasonably foreseeable loan losses based on management's assessment of various factors affecting the loan portfolio, including a review of problem loans, business conditions and loss experience and 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 management believes that it uses 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 sets forth for the periods indicated information regarding changes in the Bank's allowance for loan losses: <TABLE> <CAPTION> Nine Months Ended March 31, --------------------------- 1997 1998 ------------------------ <S> <C> <C> Total loans outstanding at end of period (1) $196,150 221,375 Average loans outstanding during period 178,875 210,260 Allowance balance at beginning of period 1,873 2,752 Provision for loan losses - 90 Charge-offs Real estate - - Commercial (3) - Consumer - - ------------------------ Total charge-offs (3) - ------------------------ Recoveries Real estate - - Commercial - - Consumer - - ------------------------ Total recoveries - - ------------------------ Net (charge-offs) recoveries (3) - ------------------------ Allowance balance at end of period $ 1,870 2,842 ======================== Ratio of net (charge-offs) recoveries during period to average loans outstanding (0.002%) -% ======================== __________ (1) Includes loans held for sale </TABLE> While pursuing its growth strategy, the Company will continue to employ prudent underwriting and sound loan monitoring procedures in order to maintain asset quality. During the nine months ended March 31, 1998, the Company had no charge-offs or recoveries. The allowance for loan losses at March 31, 1998 increased $90,000 to $2.84 million, or 1.28% of total loans. This ratio of allowance for loan losses to total Page 15
loans has declined to 1.28% at March 31, 1998 from 1.32% at June 30, 1997 due to the growth of the loan portfolio. LIQUIDITY AND SOURCE OF FUNDS The Company's primary sources of funds are customer 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. The Company 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. The Company generally maintains sufficient cash and short term investments to meet short term liquidity needs. At March 31, 1998, cash and cash equivalents totaled $65.9 million, or 20% of total assets, and investment securities classified as held to maturity with maturities of one year or less amounted to $5.7 million, or 1.8% of total assets. At March 31, 1998, the Company maintained an unused credit facility with the FHLB of Seattle for up to 20% of assets or $64.6 million. To fund the growth of the Company, management's strategy has been to build core deposits (which includes all deposits except public funds) through the development of its branch office network and commercial banking relationships. Historically, the Company has been able to retain a significant amount of its deposits as they mature. Management anticipates that the Company will continue to rely on the same sources of funds in the future and will use those funds primarily to make loans and purchase investment securities. CAPITAL Stockholders' equity at March 31, 1998 was $93.0 million compared with $27.7 million at June 30, 1997. Effective January 8, 1998, the Company closed its second step conversion and stock offering which resulted in $63 million in net proceeds. 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 March 31, 1998, the Company's leverage ratio was 27.74%, compared with 11.68% at June 30, 1997. 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%. The Company's Tier I and total capital ratios Page 16
were 45.66% and 46.91%, respectively, at March 31, 1998 compared with 15.65% and 16.90%, respectively, at June 30, 1997. 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 qualified as "well-capitalized" at March 31, 1998. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's results of operations are largely dependent upon its ability to manage interest rate risk. Management considers interest rate risk to be a significant market risk that could have a material effect on the Company's financial condition and results of operations. The Company does not currently use derivatives to manage market and interest rate risk. Subsequent to the end of the Company's most recent year end (June 30, 1997), management deployed the net proceeds from the stock offering in short term investments until these funds can be utilized in the Company's lending operations. In management's opinion, the nature of the deployment does not represent a material change in the reported market risks of the Company. YEAR 2000 ISSUES The Company utilizes various computer software programs to provide banking products and services to its customers. Many existing computer programs use only two digits to identify a year in the date field and were not designed to consider the impact of the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the Year 2000. The Year 2000 issue affects virtually all companies and organizations. The Company has identified all computer software programs used in its business and has determined the extent to which these programs are Year 2000 compliant. The Company utilizes a service bureau to perform data processing services related to the Company's loans, deposits, general ledger and other financial applications. The Company's service bureau advised the Company that it has committed resources to perform and test necessary modifications by December 31, 1998. The Company utilizes other computer software in its daily operations from automated heating, air conditioning and ventilating systems to its telephone and voice mail systems. The modification and testing of these software programs will not have a material impact on the Company's financial condition. Page 17
PART II. OTHER INFORMATION ITEM 2. CHANGE IN SECURITIES AND USE OF PROCEEDS CHANGES IN SECURITIES None to report. USE OF PROCEEDS As discussed in Note 1(a) of the Notes to Condensed Financial Statements, the Company closed its second step conversion and stock offering on January 8, 1998 which resulted in $66.1 million in gross proceeds. In connection therewith, (1) The effective date of the Securities Act registration statement was November 12, 1997 and the commission file number assigned to the registration statement was 333-35573. (2) The Company completed its stock offering effective January 8, 1998 with all securities sold pursuant to the registration statement. Ryan Beck acted as the marketing agent for the Company's stock offering. The class of securities in the offering was no par value common stock of which 9.75 million shares were registered. In the offering, 9.75 million shares were offered; 6.61 million shares were sold for $66.1 million in cash and the remaining 3.14 million shares were exchanged for shares of Heritage Bank common stock. (3) Total expenses incurred in the Company's second step conversion and offering expenses were $1.77 million. None of these expenses were paid directly or indirectly to any of the Company's directors, officers or affiliates or any person owning ten (10) percent or more of the Company's equity securities. (4) The net offering proceeds of $64.3 million were used as follows: . $1.3 million was used to fund the Company's loan to the Bank's ESOP; and . $63 million has been invested in U.S. Government and agency securities with maturities of three years or less and in interest earning deposits. This actual use of proceeds does not represent a material change from the suggested use of proceeds as disclosed in the registration statement. Page 18
ITEM 6. EXHIBITS AND REPORTS OF FORM 8-K a. EXHIBIT 2 - Plan of acquisition of North Pacific Bancorporation. b. See EXHIBIT 27-Financial Data Schedule. c. No reports on Form 8K were filed during the quarter ended March 31, 1998. 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 ______________________________ (Registrant) Date: May 15, 1998 by /s/ Donald V. Rhodes ------------------------------------- Donald V. Rhodes, Chairman, President and Chief Executive Officer (Duly Authorized Officer) Date: May 15, 1998 by /s/ James Hastings ------------------------------------- James Hastings, Vice President and Treasurer (Principal Financial and Accounting Officer) Page 19