Heritage Financial - 10-Q quarterly report FY

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2006

OR

Commission File Number 0-29480

HERITAGE FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

(360) 943-1500

(Registrant’s telephone number, including area code)

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 by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer  ¨                Accelerated filer  x                Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:

As of April 10, 2006 there were 6,302,621 common shares outstanding, with no par value, of the registrant.

Page 1

Table of Contents

HERITAGE FINANCIAL CORPORATION

FORM 10-Q

INDEX

Page 2

Table of Contents

ITEM 1. HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Dollars in thousands, except for per share data)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

Page 3

Table of Contents

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

Page 4

Table of Contents

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE THREE

MONTHS ENDED MARCH 31, 2006 AND COMPREHENSIVE INCOME FOR THE THREE MONTHS

ENDED MARCH 31, 2006 AND 2005

(In Thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

Page 5

Table of Contents

HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the three months ended March 31, 2006 and 2005

(Dollars in thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

Page 6

Table of Contents

HERITAGE FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Three Months Ended March 31, 2006 and 2005

(Unaudited)

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. Effective September 1, 2005, Central Valley Bank changed its charter from a Nationally Chartered Commercial Bank to a State Chartered Commercial 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. 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) and the Bank Insurance Fund (BIF). Heritage Bank conducts business from its main office in Olympia, Washington and its eleven branch offices located in Thurston, Pierce, and Mason Counties of Washington State. Central Valley Bank is also a Washington state-chartered commercial bank whose deposits are insured by the FDIC under the BIF. Central Valley Bank conducts business from its main office in Toppenish, Washington and its five branch offices located in Yakima and Kittitas Counties of Washington State.

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 condensed 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 condensed consolidated financial statements should be read with our December 31, 2005 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 three months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ended December 31, 2006. 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.

Certain amounts in the consolidated financial statements for the prior year have been reclassified to conform to the current consolidated financial statement presentation.

Page 7

Table of Contents

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.

As of March 31, 2006 and 2005, there were no anti-dilutive shares outstanding related to options to acquire common stock.

(b.) Cash Dividend Declared

On March 23, 2006, we announced a quarterly cash dividend of 19.5 cents per share payable on April 28, 2006 to stockholders of record on April 17, 2006.

NOTE 3. Share Based Payment

The Company maintains a number of stock-based incentive programs, which are discussed in more detail in Note 4. Prior to 2006, the Company applied the intrinsic value-based method, as outlined in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB No. 25”) and related interpretations, in accounting for stock options granted under these programs. Under the intrinsic value-based method, no compensation expense was recognized if the exercise price of the Company’s employee stock options equaled the market price of the underlying stock on the date of the grant. Accordingly, prior to 2006, no compensation cost was recognized in the accompanying consolidated statements of income on stock options granted to employees, since all options granted under the Company’s share incentive programs had an exercise price equal to the market value of the underlying common stock on the date of the grant.

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123R (“SFAS No. 123R”) “Share-based Payment.” This statement replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and supersedes APB No. 25. SFAS No. 123R requires that all stock-based compensation be recognized as an expense in the financial statements and that such cost be measured at the fair value of the award on the grant date. This statement was adopted using the modified prospective method of application, which requires the Company to recognize compensation expense on a prospective basis. Therefore, prior period financial statements have not been restated. Under this method, in addition to reflecting compensation expense for new share-based awards, expense is also recognized to reflect the remaining service period of awards that had been included in pro forma disclosures in prior periods.

Page 8

Table of Contents

Total stock-based compensation expense (excluding ESOP expense) in the first quarter of 2006 was $135,000 ($115,000 after tax), or $0.02 for basic and diluted earnings per share, respectively. Included in this expense is $90,000 ($86,000 after tax), or $0.01 for basic and diluted earnings per share, respectively, attributable to the Company’s adoption of SFAS 123R. As of March 31, 2006, the total unrecognized compensation expense related to non-vested stock awards was $510,000 and the related weighted average period over which it is expected to be recognized is approximately 2.1 years.

The following table illustrates the effect on net income and earnings per share as if SFAS 123R had been applied to all outstanding awards for the three months ended March 31, 2005 (dollars in thousands, except per share amounts):

The fair value of options granted during the three months ended March 31, 2006 and 2005 is estimated on the date of grant using the Black-Scholes option pricing model based on the assumptions noted in the following table. The expected term of share options is derived from historical data and represents the period of time that share options granted are expected to be outstanding. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatility is based on historical volatility of Company shares. Expected dividend yield is based on dividends expected to be paid during the expected term of the share options.

NOTE 4. Stock Option and Award Plans

In September 1994, Heritage Bank’s stockholders approved the adoption of the 1994 stock option plan, providing for the award of a restricted stock award to a key officer, incentive stock options to employees and nonqualified stock options to directors of the Bank at the discretion of the Board of Directors. On September 24, 1996, Heritage Bank’s stockholders approved the adoption of the 1997 stock option plan, which is generally similar to the 1994 plan. On October 15, 1998, the Company’s stockholders approved the adoption of the 1998 stock option plan, which is similar to the 1994 and 1997 plans. The 1998 plan does not affect any options granted under the 1994 or 1997 plans. On April 25, 2002, The Company’s stockholders approved the adoption of the 2002 Incentive Stock Option Plan, the 2002 Director Nonqualified Stock Option Plan and the 2003 Restricted Stock Plan, which are generally similar to the 1994, 1997 and 1998 stock plans.

Page 9

Table of Contents

Under these stock option plans, on the date of grant, the exercise price of the option must at least equal the market value per share of the Company’s common stock. The 1994 plan provides for the grant of options and stock awards up to 362,246 shares. The 1997 plan provides for the granting of options and stock awards up to 270,333 common shares. The 1998 plan provides for the grant of stock options for up to 414,750 and stock awards for up to 69,431 shares. The 2002 Incentive Stock Option plan provides for the grant of stock options for up to 451,500 shares. The 2002 Director Nonqualified Stock Option plan provides for the grant of stock options for up to 73,500 shares. The 2002 Restricted Stock plan provides for the grant of stock awards for up to 52,500 shares.

Stock options generally vest ratably over three years and expire five years after they become exercisable which amounts to an average term of seven years. Restricted Stock awards issued have a five-year cliff vesting. The Company issues new shares to satisfy share option exercises.

The following table summarizes stock option and award activity for the three months ended March 31, 2006.

Financial data pertaining to outstanding stock options and exercisable stock options at March 31, 2006 follows:

Page 10

Table of Contents

At March 31, 2006, the aggregate intrinsic value of stock options outstanding and stock options exercisable was $7.1 million and $5.9 million, respectively. The total intrinsic value of options exercised during the three months ended March 31, 2006 and 2005, was $390,000 and $292,000, respectively. The weighted average remaining contractual life of exercisable option shares as of March 31, 2006 was 3.4 years. The total fair value of shares vested during the three months ended March 31, 2006 and 2005 was $388,000 and $336,000 respectively.

Page 11

Table of Contents

ITEM 2. 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, 2005 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 $1.4 million (0.2%) to $752.5 million as of March 31, 2006 from the December 31, 2005 balance of $751.1 million. Deposits increased $24.0 million (3.8%) to $660.5 million as of March 31, 2006 from the December 31, 2005 balance of $636.5 million. For the same period, net loans, which include loans held for sale but are net of the allowance for loan losses, increased $8.3 million (1.3%) to $652.1 million as of March 31, 2006 from the December 31, 2005 balance of $643.8 million. Commercial loans increased by $10.2 million to $370.1 million as of March 31, 2006 from the December 31, 2005 balance of $359.8 million. Commercial loans continue to be the largest segment of loans at 56.0% and 55.2% as a percentage of total loans as of March 31, 2006 and December 31, 2005, respectively.

As of March 31, 2006, we have repurchased a total of 5,935,138 shares, or 52.1% of the total outstanding at March 31, 1999, which was the inception of our stock repurchase programs, at an average price of $12.15 per share. We began our current 5% repurchase program on August 2, 2004 with the goal to repurchase approximately 309,750 shares. During the quarter ended March 31, 2006, we repurchased 105 shares at an average price of $24.50. We have repurchased 87,172 shares under the eighth program at an average price of $20.77.

Earnings Summary

Net income was $0.40 per diluted share for the three months ended March 31, 2006 and March 31, 2005. Actual earnings for the three months ended March 31, 2006 were $2,564,000 compared to $2,563,000 for the same period in 2005.

Return on average equity for the quarter ended March 31, 2006 was 15.20% compared to 16.51% for the same period last year. Average equity increased by $5.4 million to $68.4 million for the three months ended March 31, 2006 versus $63.0 million for the same period last year while net income increased by $1,000.

Page 12

Table of Contents

Net Interest Income

Net interest income before provision for loan losses for the three months ended March 31, 2006 increased 1.9% to $8,485,000 from $8,323,000 for the same quarter in 2005. The net interest margin (net interest income divided by average interest earning assets) decreased to 4.96% for the current quarter from 5.17% for the same quarter last year. One of the methods in which we have been able to maintain our net interest margin near 5.0% is our continued focus on increasing noninterest bearing deposits. Noninterest bearing deposits averaged $88.5 million for the quarter ended March 31, 2006 versus $81.2 million for the quarter ended March 31, 2005, an increase of 9.1%. Achieving a margin near 5.0% will be a challenge this year. Short-term interest rates have increased at a much faster pace than longer-term interest rates over the last several months and this has had the effect of narrowing our net interest margin. While we continue to focus on increasing our asset sensitivity, a continuation of a “flat” yield curve and a very competitive business environment will have the effect of reducing our net interest margin further.

Interest income increased $1.7 million, or 16.4%, for the three months ended March 31, 2006 as compared to the first quarter last year and interest expense increased $1.6 million, or 68.6%, during this same period. Loans averaged $644.0 million with an average yield of 7.50% for the three months ended March 31, 2006 compared to average loans of $597.9 million with an average yield of 6.91% for the same period in 2005. Certificates of deposit averaged $285.4 million with an average cost of 3.66% for the three months ended March 31, 2006 compared to $243.5 million with an average cost of 2.44% for the same period in 2005.

Provision for Loan Losses

The provision for loan losses was $140,000 for the three months ended March 31, 2006, which was $25,000 less than the provision for loan losses during the first quarter of 2005. The provision for loan losses during the fourth quarter of 2005 was $225,000. The provision for loan losses decrease was primarily due to net recoveries of $119,000 in the first quarter of 2006.

Noninterest Income

Noninterest income increased 20.0% to $1,771,000 for the three months ended March 31, 2006 compared with $1,476,000 for the same quarter in 2005. The increase is due primarily to increases in service charges on deposits of $147,000 and merchant visa income of $84,000.

Noninterest Expense

Noninterest expense increased 7.9% to $6,285,000 during the three months ended March 31, 2006 compared to $5,826,000 for the same period during 2005. Salaries and employee benefits increased by $360,000 for the three months ended March 31, 2006 compared to the same period last year. This increase was primarily the result of new loan officer hires in the second half of last year and in the first quarter of 2006. In addition, the adoption of the new accounting pronouncement related to stock option compensation increased expenses by $90,000. Merchant visa expense increased $65,000 for the three months ended March 31, 2006 compared to the same period last year.

The efficiency ratio for the quarter ended March 31, 2006 was 61.28% compared to 59.46% for the comparable quarter in 2005. The efficiency ratio increase is primarily a result of the increased expenses incurred to hire new lending staff and the opening of the Sumner branch coupled with slower than anticipated loan growth in the first quarter of this year. The efficiency ratio consists of noninterest expense divided by the sum of net interest income before provision for loan losses plus noninterest income.

Page 13

Table of Contents

Lending Activities

As indicated in the table below, total loans (including loans held for sale) increased to $660.8 million at March 31, 2006 from $652.3 million at December 31, 2005.

Nonperforming Assets

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

Nonperforming assets increased to $1,752,000, or 0.23% of total assets at March 31, 2006 from $1,207,000, or 0.16% of total assets at December 31, 2005. We believe that we are adequately reserved for losses in the portfolio as of March 31, 2006. Potential problem loans are those loans that are currently accruing interest, but which are considered possible

Page 14

Table of Contents

credit problems because financial information of the borrowers causes us concerns as to their ability to comply with the present repayment program and could result in placing the loan on nonaccrual.

Analysis of Allowance for Loan Losses

Management maintains an allowance for loan losses to absorb estimated credit losses associated with the loan 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 may 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.

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, unforeseen market conditions arise or if we are directed to make adjustments to the allowance for loan losses by our regulators.

Page 15

Table of Contents

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

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 three months ended March 31, 2006 increased by $259,000 to $8.8 million from $8.5 million at December 31, 2005. Based on management’s assessment of loan quality, the Company believes that its reserve for loan losses is at an appropriate level under current economic conditions.

Liquidity and Sources of Funds

Our primary sources of funds are customer and local government deposits, 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 March 31, 2006, cash and cash equivalents totaled $21.5 million, and investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $15.1 million, or 2.0% of total assets. At March 31, 2006, our banks maintained a credit facility with the FHLB of Seattle for $139.2 million, with $15.2 million in FHLB borrowings as of March 31, 2006.

Page 16

Table of Contents

Capital

Stockholders’ equity at March 31, 2006 was $68.0 million compared with $66.1 million at December 31, 2005. During the period, we declared dividends of $1.2 million, realized income of $2.6 million, recorded $44,000 in unrealized losses on securities available for sale, net of tax, and realized the effects of exercising stock options, stock option compensation and earned ESOP and restricted stock shares totaling $597,000.

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 March 31, 2006 our leverage ratio was 8.4% compared with 8.2% at December 31, 2005. 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 9.9% and 11.1%, respectively, at March 31, 2006 compared with 9.5% and 10.8%, respectively, at December 31, 2005.

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 March 31, 2006.

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, 2005.

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.

Page 17

Table of Contents

(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 March 31, 2006.

(b) Changes in internal control over financial reporting. We made no changes in our internal controls over financial reporting that occurred during the Company’s quarter ended March 31, 2006, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Page 18

Table of Contents

PART II. OTHER INFORMATION

None

There have been no material changes from the risk factors as previously disclosed in Item 1A to Part I of the Company’s Annual Report on Form 10-K for the year ended December 31, 2005.

The Company has had various stock repurchase programs since March 1999. In August 2004, the Board of Directors approved a new stock repurchase plan, allowing the Company to repurchase up to 5% of the then outstanding shares, or approximately 309,750 shares over a period of eighteen months. This marked the Company’s eighth stock repurchase plan. On January 25, 2006, the Board of Directors authorized an eighteen month extension to this program. During the quarter ended March 31, 2006, the Company repurchased 105 shares at an average price of $24.50. In total, the Company has repurchased 87,172 shares at an average price of $20.77 under this plan.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended March 31, 2006.

None

None

None

Page 19

Table of Contents

Page 20

Table of Contents

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.

Page 21