UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2004
OR
Commission File Number 0-29480
HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
(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 last practicable date:
As of October 15, 2004 there were 5,942,446 common shares outstanding, with no par value, of the registrant.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes x No ¨
INDEX
Financial Statements
Condensed Consolidated Financial Statements (Unaudited):
Condensed Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2004 and 2003
Condensed Consolidated Statements of Financial Condition as of September 30, 2004 and December 31, 2003
Condensed Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2004 and Comprehensive Income for the Three and Nine Months Ended September 30, 2004 and 2003
Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003
Notes to Condensed Consolidated Financial Statements
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Quantitative and Qualitative Disclosures About Market Risk
Controls and Procedures
PART II.
Other Information
Legal Proceedings
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Submission of Matters to a Vote of Security Holders
Exhibits
Signatures
Employment Agreement
Certifications
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CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except for per share data)
(Unaudited)
Three Months Ended
September 30,
Nine Months Ended
INTEREST INCOME:
Loans
Investment securities and FHLB dividends
Interest bearing deposits and fed funds sold
Total interest income
INTEREST EXPENSE:
Deposits
Borrowed funds
Total interest expense
Net interest income
Provision for loan losses
Net interest income after provision for loan losses
NONINTEREST INCOME:
Gains on sales of loans
OREO income
Service charges on deposits
Rental income
Merchant visa income
Other income
Total noninterest income
NONINTEREST EXPENSE:
Salaries and employee benefits
Building occupancy
Data processing
Marketing
Office supplies and printing
Merchant visa
Other expense
Total noninterest expense
Income before federal income taxes
Federal income taxes
Net income
Earnings per share:
Basic
Diluted
Dividends declared per share:
See Notes to Condensed Consolidated Financial Statements.
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CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands)
Cash on hand and in banks
Interest earning deposits
Federal funds sold
Investment securities available for sale
Investment securities held to maturity
Loans held for sale
Loans receivable
Less: Allowance for loan losses
Loans receivable, net
Other real estate owned
Premises and equipment, net
Federal Home Loan Bank and Federal Reserve stock, at cost
Accrued interest receivable
Prepaid expenses and other assets
Deferred federal income taxes, net
Goodwill
Total assets
Advances from Federal Home Loan Bank
Other borrowings
Accrued expenses and other liabilities
Total liabilities
Stockholders’ equity:
Common stock, no par value per share, 15,000,000 shares authorized; 5,908,192 and 6,192,996 shares outstanding at September 30, 2004 and December 31, 2003, respectively
Unearned compensation - ESOP and other
Retained earnings, substantially restricted
Accumulated other comprehensive income (loss)
Total stockholders’ equity
Commitments and contingencies
Total liabilities and stockholders’ equity
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CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE NINE
MONTHS ENDED SEPTEMBER 30, 2004 AND COMPREHENSIVE INCOME FOR THE THREE
AND NINE MONTHS ENDED SEPTEMBER 30, 2004 and 2003
(In Thousands)
Balance at December 31, 2003
Earned ESOP shares, incentive stock options and restricted stock awards
Stock repurchase
Exercise of stock options
Increase in unrealized gain on securities available for sale, net of tax
Cash dividends declared
Balance at September 30, 2004
Change in unrealized gain (loss) on securities available for sale, net of tax of $286, $(149), $(25), and $(144)
Comprehensive income
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the nine months ended September 30, 2004 and 2003
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities
Depreciation and amortization
Federal Home Loan Bank stock dividends and Federal Reserve Stock
Recognition of compensation related to ESOP shares, incentive stock options and restricted stock awards
Deferred loan fees, net of amortization
Net decrease in loans held for sale
Net change in accrued interest receivable, prepaid expenses and other assets, accrued expenses and other liabilities
(Gain) loss on sale of premises and equipment
Gain on sale of other real estate owned
Net cash provided by operating activities
Cash flows from investing activities:
Loans originated, net of principal payments
Proceeds from other real estate owned
Proceeds from maturities/calls of investment securities available for sale
Proceeds from maturities/calls of investment securities held to maturity
Purchase of investment securities available for sale
Purchase of premises and equipment
Proceeds from sale of premises and equipment
Net cash used in investing activities
Cash flows from financing activities:
Net increase in deposits
Net increase (decrease) in borrowed funds
Cash dividends paid
Proceeds from exercise of stock options
Stock repurchased
Net cash provided by financing activities
Net decrease in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental disclosures of cash flow information:
Cash payments for:
Interest expense
Net charge offs
Loans transferred to/from other real estate owned
Nonqualified stock options
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Three and Nine Months Ended September 30, 2004 and 2003
NOTE 1. Description of Business and Basis of Presentation
(a.) Description of Business
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. Effective September 1, 2004, Heritage Savings Bank switched its charter from a State Chartered Savings Bank to a State Chartered Commercial Bank and changed its legal name from Heritage Savings Bank to Heritage Bank.
We are primarily engaged in the business of planning, directing, and coordinating the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank, N.A. Heritage Bank is a Washington state-chartered commercial bank whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC) under the Savings Association Insurance Fund (SAIF). Heritage 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 including agribusiness 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.
(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 with our December 31, 2003 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, 2004 are not necessarily indicative of the results that may be expected for the year ended December 31, 2004. 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 December 2003, the FASB amended FAS No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits—an amendment of FASB Statements No. 87, 88, and 106. The provisions of this Statement are effective for financial statements with fiscal years ending after December 15, 2003. The Statement revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not change the measurement or recognition of those plans required by FASB Statements No. 87, Employers’ Accounting for Pensions, No. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, and No. 106, Employers’
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Accounting for Postretirement Benefits Other Than Pensions. This Statement retains the disclosure requirements contained in FASB Statement No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits, which it replaces. It requires additional disclosures to those in the original Statement 132 about the assets, obligations, cash flows, and net periodic benefit cost of defined benefit pension plans and other defined benefit postretirement plans. The required information should be provided separately for pension plans and for other postretirement benefit plans. Application of this Interpretation did not have an effect on our financial statements.
The Emerging Issues Task Force (EITF) Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” In connection with its discussion of EITF Issue No. 02-14, “Whether the Equity Method of Accounting Applies When an Investor Does Not Have an Investment in Voting Stock of an Investee but Exercises Significant Influence through Other Means,” at the November 21, 2002 meeting, the Task Force discussed the meaning of other-than-temporary impairment and its application to certain investments carried at cost. The Task Force requested that the FASB staff consider other impairment models within U.S. GAAP when developing its views. At the November 25, 2003 EITF meeting, the Board ratified a consensus that certain quantitative and qualitative disclosures for periods ending after December 15, 2003 should be required for securities accounted for under Statement 115 that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. FASB has delayed the effective date of paragraph 10-20 of Issue 03-1. This delay does not suspend the requirement to recognize other-than-temporary impairments as required by existing authoritative literature. Application of this Interpretation did not have a material effect on our financial statements.
In December 2003, the FASB issued FASB Interpretation (FIN) No. 46 (revised December 2003), Consolidation of Variable Interest Entities, which addressed how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities, which was issued in January 2003. The Company will be required to apply FIN 46R to variable interests in variable interest entities (VIEs) created after December 31, 2003. For VIEs created before January 1, 2004, the Interpretation will be applied beginning on January 1, 2005. For any VIEs that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities and noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities, and noncontrolling interests of the VIE. Application of this Interpretation did not have an effect on our financial statements.
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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 noted periods.
Basic:
Weighted average shares outstanding
Less: Weighted average unvested restricted stock awards
Basic weighted average shares outstanding
Diluted:
Incremental shares from unexercised stock options and unvested restricted stock awards
As of September 30, 2004, there were 257,315 anti-dilutive shares and as of September 30, 2003, there were no anti-dilutive shares outstanding related to options to acquire common stock.
(b.) Cash Dividend Declared
On September 23, 2004, we announced a quarterly cash dividend of 16.5 cents per share payable on October 29, 2004 to stockholders of record on October 15, 2004.
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NOTE 3. Stock Based Compensation
The Company measures its employee stock-based compensation arrangements using the provisions outlined in Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, which is an intrinsic value-based method of recognizing compensation costs. The Company has adopted the disclosure-only provisions of FAS No. 123, Accounting for Stock-Based Compensation. As most of the Company’s stock options have no intrinsic value at grant date, compensation cost generally has not been recognized for its stock option plan activity. However, compensation expense was recognized during 2003 and 2004 resulting from restricted stock awards and certain incentive stock options. If the Company had elected to recognize compensation cost on the fair value at the grant dates for awards under its plans, consistent with the method prescribed by FAS No. 123, net income and earnings per share would have been changed to the pro forma amounts for the following periods:
Net Income:
As Reported
Plus Compensation costs recognized under APB No. 25, net of taxes
Less FAS No. 123 compensation costs, net of taxes
Pro Forma
Basic earnings per share:
Diluted earnings per share:
The compensation expense included in the pro forma net income is not likely to be representative of the effect on reported net income for future years because options vest over several years and additional awards generally are made each year.
The fair value of options granted during the nine months ended September 30, 2004 and 2003 is estimated on the date of grant using the Black-Scholes options pricing model. There were no options granted during the three months ended September 30, 2004 and 2003. The following assumptions were used to calculate the fair value of the options granted:
Grant period ended
September 30, 2004
September 30, 2003
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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 the Company. The information contained in this section should be read with the unaudited condensed consolidated financial statements and its accompanying notes, and the December 31, 2003 audited consolidated financial statements and its accompanying notes included in our recent Annual Report on Form 10-K.
Statements concerning future performance, developments or events, expectations for growth and market forecasts, and any other guidance on future periods, constitute forward-looking statements and 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 our filings with the Securities and Exchange Commission.
Overview
Heritage Financial Corporation is a bank holding company, which primarily engages in the business activities of our wholly owned subsidiaries: Heritage Bank and Central Valley Bank. We provide financial services to our local communities with an ongoing strategic focus in expanding our commercial lending relationships, market expansion and a continual focus on asset quality. Effective January 8, 1998, our common stock began to trade on the NASDAQ National Market under the symbol “HFWA”.
Financial Condition Data
Total assets increased $39.8 million (6.2%) to $680.7 million as of September 30, 2004 from the December 31, 2003 balance of $640.9 million. Deposits increased $46.7 million (8.6%) to $588.5 million as of September 30, 2004 from the December 31, 2003 balance of $541.8 million. For the same period, net loans, which include loans held for sale but are net of the allowance for loan losses, increased $57.4 million (11.2%) to $571.1 million as of September 30, 2004 from the December 31, 2003 balance of $513.7 million. Commercial loans increased by $26.1 million to $292.4 million as of September 30, 2004 from the December 31, 2003 balance of $266.3 million. Commercial loans continue to be the largest segment of loans at 50.5% and 51.1% as a percentage of total loans as of September 30, 2004 and December 31, 2003, respectively.
As of September 30, 2004, we have repurchased a total of 5,573,350 shares, or 51.3% of the total outstanding at March 1999, which was the inception of our stock repurchase programs, at an average price of $12.63 per share. We began our current 5% repurchase program in July 2004 with the goal to repurchase approximately 295,000 shares. During the quarter ended September 30, 2004, we repurchased 3,859 shares at an average price of $20.66, which also represents the total purchased to date under the eighth program.
Earnings Summary
Net income for the three months ended September 30, 2004 was $0.41 per diluted share compared to $0.37 per diluted share for the same period last year. Actual earnings for the three months ended September 30, 2004 were $2,443,000 compared to $2,413,000 for the same period in 2003, an increase of 1.2%. Net income for the nine months ended September 30, 2004 was $1.13 per diluted share compared to $0.98 per diluted share for the same period last year. Actual earnings for the nine months ended September 30, 2004 were $6,952,000 compared to $6,680,000 for the same period in 2003, an increase of 4.1%.
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Return on average equity for the quarter ended September 30, 2004 improved to 16.53% from 14.78% for the same period last year. Average equity declined by $6.2 million to $59.1 million for the three months ended September 30, 2004 versus $65.3 million for the same period last year while net income increased by $30,000. For the nine months ended September 30, 2004, return on average equity increased to 15.32% from 12.82% for the nine months ended September 30, 2003. For the nine months ended September 30, 2004, average equity decreased by $8.9 million to $60.5 million from $69.5 million and net income increased by $272,000 for the same period last year.
Net Interest Income
Net interest income before provision for loan losses for the three months ended September 30, 2004 increased 6.5% to $8,015,000 from $7,529,000 for the same quarter in 2003. Net interest income before provision for loan losses for the nine months ended September 30, 2004 increased 6.2% to $23,512,000 from $22,130,000 for the same period in 2003. The net interest margin (net interest income divided by average interest earning assets) decreased to 5.10% for the current quarter from 5.46% for the same quarter last year. The net interest margin decreased to 5.13% for the nine months ended September 30, 2004 from 5.42% for the same period in 2003.
We have been able to maintain our margin over 5.00% primarily by reducing the levels of our more expensive deposits and increasing the levels of our noninterest bearing deposits. Noninterest bearing deposits averaged $80.3 million for the quarter ended September 30, 2004 versus $65.2 million for the quarter ended September 30, 2003, an increase of 23.2%. Noninterest bearing deposits averaged $74.3 million for the nine months ended September 30, 2004 versus $62.0 million for the nine months ended September 30, 2003, an increase of 19.8%. However, we are seeing our margin decline as a result of rising short-term costs and the continued low levels on loan yields. If the current rate climate persists, we expect to see continued downward pressure on our net interest margin.
Interest income increased $555,000, or 6.0%, for the three months ended September 30, 2004 as compared to the third quarter last year and interest expense increased $69,000, or 3.9%, during this same period. Interest income for the nine months ended September 30, 2004 increased $912,000, or 3.3%, as compared to the same period last year and interest expense declined $470,000, or 8.3%, during this same period. Loans averaged $539.1 million with an average yield of 6.71% for the nine months ended September 30, 2004 compared to average loans of $474.8 million with an average yield of 7.37% for the same period in 2003. Certificates of deposit averaged $217.8 million with an average cost of 1.94% for the nine months ended September 30, 2004 compared to $201.9 million with an average cost of 2.46% for the same period in 2003.
Provision for Loan Losses
The provision for loan losses was $150,000 for the three months ended September 30, 2004, which was the same as the third quarter of 2003. The provision for loan losses declined to $510,000 for the nine months ended September 30, 2004 from $975,000 for the same period in 2003. We believe that the 2003 provisions were necessary to ensure that we maintained our allowance for loan losses at an adequate level given the increased risk in our portfolio that resulted from weak economic conditions. However, during the second quarter of 2003 our largest non-accruing loans was re-paid and the anticipated loss on this credit was not realized. Subsequent to that we were able to reduce our loan loss provision.
Noninterest Income
Noninterest income decreased 24.9% to $1,531,000 for the three months ended September 30, 2004 compared with $2,039,000 for the same quarter in 2003. Noninterest income decreased 15.2% to $4,797,000 for the nine months ended September 30, 2004 from $5,656,000 for the same period in 2003. The decrease is the result of significant declines in mortgage banking income from near record levels in 2003. We did experience increases in merchant visa income and service charges on deposits but not enough to offset the declines in mortgage banking income. During the nine months ended September 30, 2003 mortgage banking income was up 91.8% compared to the same period in 2002. However, during the nine months ended September 30, 2004, mortgage banking income was down 66.7% compared to the same period last year. Mortgage banking income declines are primarily due to reduced refinance activity. We have taken
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steps to reduce expenses including staff reductions in this area. Merchant visa income increased 20.9% to $537,000 and to $1,404,000 for the three months ended and the nine months ended September 30, 2004, respectively, compared to $444,000 and $1,161,000 for the same respective periods last year. Service charges on deposits increased 10.6% to $678,000 for the three months ended September 30, 2004 compared to $613,000 for the same quarter last year. Service charges on deposits increased 5.5% to $1,925,000 for the nine months ended September 30, 2004 compared to $1,825,000 for the same period last year.
Noninterest Expense
Noninterest expense increased 0.4% to $5,742,000 during the three months ended September 30, 2004 compared to $5,717,000 for the same period during 2003. Noninterest expense increased 5.0% to $17,409,000 for the nine months ended September 30, 2004 from $16,575,000 for the same period last year. Salaries and employee benefits remained level at $2,960,000 for the three months ended September 30, 2004 compared to $2,961,000 for the same period last year. Salaries and benefits increased 5.6% to $9,196,000 for the nine months ended September 30, 2004 from $8,711,000 for the same period last year. Salaries and benefits were flat in the third quarter primarily as a result of the steps taken to reduce expenses in mortgage banking. Salaries for the nine month period, were up over last year as a result of normal salary increases, increased full time equivalents and insurance costs. Merchant visa expense increased 13.6% to $417,000 for the three months ended September 30, 2004 from $367,000 for the same period last year. Merchant visa expense increased 15.9% to $1,102,000 for the nine months ended September 30, 2004 from $951,000 for the same period last year.
The efficiency ratio for the quarter ended September 30, 2004 was 60.15% compared to 59.76% for the comparable quarter in 2003. However, the third quarter efficiency ratio is down from the second quarter ended June 30, 2004 of 62.18%. The efficiency ratio for the nine months ended September 30, 2004 was 61.50% compared to 59.65% for the same period last year. The efficiency ratio increases are primarily a result of growth in noninterest expense, as discussed above, during the above-mentioned periods. The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision plus noninterest income.
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Lending Activities
As indicated in the table below, total loans increased to $579.3 million at September 30, 2004 from $521.4 million at December 31, 2003.
At
2004
December 31,2003
Commercial
Real estate mortgages
One-to-four family residential
Five or more family residential and commercial properties
Total real estate mortgages
Real estate construction
Total real estate construction
Consumer
Gross loans
Less: deferred loan fees
Total loans
Nonperforming Assets
The following table describes our nonperforming assets for the dates indicated.
September 30,2004
Nonaccrual loans
Restructured loans
Total nonperforming loans
Total nonperforming assets
Accruing loans past due 90 days or more
Potential problem loans
Allowance for loan losses
Nonperforming loans to loans
Allowance for loan losses to loans
Allowance for loan losses to nonperforming loans
Nonperforming assets to total assets
Nonperforming assets decreased to $333,000, or 0.05% of total assets at September 30, 2004 from $686,000, or 0.11% of total assets at December 31, 2003. We believe that we are adequately reserved for potential losses.
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Analysis of Allowance for Loan Losses
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 determine 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 classified loans.
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. However, 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.
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.
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The following table summarizes the changes in our allowance for loan losses:
Total loans outstanding at end of period (1)
Average loans outstanding during period
Allowance balance at beginning of period
Charge offs:
Real estate
Agriculture
Total charge offs
Recoveries:
Total recoveries
Allowance balance at end of period
Allowance for loan loss to loans
Ratio of net charge offs during period to average loans outstanding
While pursuing our growth strategy, we continue to employ prudent underwriting and sound monitoring procedures to maintain asset quality. The allowance for loan losses during the nine months ended September 30, 2004 increased by $500,000 to $8.2 million from $7.7 million at December 31, 2003. The growth in the allowance was due to a $510,000 provision, which was partially offset by $39,000 in net charge offs during the period. While pleased with the low level of charge offs in the first nine months of this year, we cannot predict with any certainty the future level of charge offs.
Liquidity and Sources of Funds
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 Federal Home Loan Bank (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, 2004, cash and cash equivalents totaled $27.0 million, and investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $1.9 million, or 0.3% of total assets. At September 30, 2004, our banks maintained a credit facility with the FHLB of Seattle for $120.3 million, with $28.1 million in FHLB borrowings as of September 30, 2004.
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Capital
Stockholders’ equity at September 30, 2004 was $59.0 million compared with $62.2 million at December 31, 2003. During the period, we repurchased $8.2 million of Heritage Financial Corporation stock, declared dividends of $2.9 million, realized income of $7.0 million, recorded $49,000 in unrealized losses on securities available for sale, net of tax, and realized the effects of exercising stock options, earned ESOP and restricted stock shares totaling $968,000.
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, 2004 our leverage ratio was 7.8% compared with 9.0% at December 31, 2003. 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 9.5% and 10.7%, respectively, at September 30, 2004 compared with 10.4% and 11.7%, respectively, at December 31, 2003.
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, 2004.
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, 2003.
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 have no material risk with foreign currency exchange rate risk or commodity price risk.
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(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, the Chief Executive and Chief Financial officers of the Company concluded that the Company’s disclosure controls and procedures were adequate as of September 30, 2004.
(b) Changes in internal control over financial reporting. We made no significant changes in our internal controls over financial reporting that occurred during the Company’s quarter ended September 30, 2004, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits
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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.
/s/ Donald V. Rhodes
/s/ Edward D. Cameron
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