Heritage Financial - 10-Q quarterly report FY

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2008

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.

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 July 09, 2008 there were 6,690,790 common shares outstanding, with no par value, of the registrant.

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HERITAGE FINANCIAL CORPORATION

FORM 10-Q

INDEX

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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.

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY FOR THE SIX MONTHS ENDED JUNE 30, 2008 AND COMPREHENSIVE INCOME FOR THE THREE AND SIX MONTHS ENDED

JUNE 30, 2008 AND 2007

(In Thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

For the six months ended June 30, 2008 and 2007

(Dollars in thousands)

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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HERITAGE FINANCIAL CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Three and Six Months Ended June 30, 2008 and 2007

(Unaudited)

NOTE 1. Description of Business and Basis of Presentation

(a.) Description of Business

Heritage Financial Corporation (Company) 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 (acquired by the Company in March 1999) 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. The deposits of Heritage Bank and Central Valley Bank are insured by the Federal Deposit Insurance Corporation (FDIC) under the Deposit Insurance Fund (DIF). Heritage Bank conducts business from its main office in Olympia, Washington and its thirteen branch offices located in Thurston, Pierce, Mason and south King Counties of Washington State. 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 U.S. generally accepted accounting principles for complete financial statements. These condensed consolidated financial statements should be read with our December 31, 2007 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 and six months ended June 30, 2008 are not necessarily indicative of the results that may be expected for the year ended December 31, 2008. 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.) Significant Accounting Policies

The significant accounting policies used in preparation of our consolidated financial statements are disclosed in our 2007 Annual Report on Form 10-K. There have not been any other material changes in our significant accounting policies compared to those contained in our 2007 10-K disclosure for the year ended December 31, 2007.

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.

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Potential dilutive shares are excluded from the computation of earnings per share if their effect is anti-dilutive. For the six months ended June 30, 2008 and 2007, anti-dilutive shares outstanding related to options to acquire common stock totaled 455,857 and 104,122, respectively, as the exercise price was in excess of the market value.

(b.) Cash Dividend Declared

On June 24, 2008, we announced a quarterly cash dividend of 21.0 cents per share payable on July 30, 2008 to stockholders of record on July 15, 2008.

NOTE 3. Share Based Payment

The Company maintains a number of stock-based incentive programs, which are discussed in more detail in Note 4.

Total stock-based compensation expense (excluding ESOP expense) for the six months ended June 30, 2008 and 2007 were as follows:

As of June 30, 2008, the total unrecognized compensation expense related to non-vested stock awards was $942,000 and the related weighted average period over which it is expected to be recognized is approximately 2.9 years.

The fair value of options granted during the six months ended June 30, 2008 and 2007 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

On September 24, 1996, Heritage Bank’s stockholders approved the adoption of the 1997 stock option plan. On October 15, 1998, the Company’s stockholders approved the adoption of the 1998 stock option plan, which is similar to the 1997 plan. The 1998 plan does not affect any options granted under the 1997 plan. 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 2002 Restricted Stock Plan, which are generally similar to the 1997 and 1998 stock plans. On April 27, 2006, the Company’s stockholders approved the adoption of the 2006 Incentive Stock Option Plan, the 2006 Director Nonqualified Stock Option Plan and the 2006 Restricted Stock Plan, which are generally similar to the 1997, 1998 and 2002 stock plans.

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 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 shares and stock awards for up to 69,431 shares. The 2002 and 2006 Incentive Stock Option plans provide for the grant of stock options for up to 451,500 and 400,000 shares, respectively. The 2002 and 2006 Director Nonqualified Stock Option Plans provide for the grant of stock options for up to 73,500 and 75,000 shares, respectively. The 2002 and 2006 Restricted Stock Plans provide for the grant of stock awards for up to 52,500 and 25,000 shares, respectively.

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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 and restricted stock awards.

The following table summarizes stock option activity for the six months ended June 30, 2008.

The total intrinsic value of options exercised during the six months ended June 30, 2008 and 2007, was $162,000 and $1,204,000, respectively. The total fair value of options vested during the six months ended June 30, 2008 and 2007 was $113,000 and $1,126,000, respectively.

The following table summarizes restricted stock award activity for the six months ended June 30, 2008.

NOTE 5. Fair Value Accounting

Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standards No. 157 (“SFAS No. 157”) “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value under Generally Accepted Accounting Principles (“GAAP”) and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements.

In accordance with SFAS No. 157, we group our financial assets and financial liabilities measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

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The following table summarizes the balances of assets and liabilities measured at fair value on a recurring basis at June 30, 2008.

The following table summarizes the balances of assets and liabilities measured at fair value on a nonrecurring basis at June 30, 2008, and the total losses resulting from these fair value adjustments for the six months ended June 30, 2008

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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, 2007 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”.

The following table provides relevant net interest income information for selected time periods. The average loan balances presented in the table are net of allowances for loan losses. Nonaccrual loans have been included in the tables as loans carrying a zero yield. Yields on tax-exempt securities and loans have not been stated on a tax-equivalent basis.

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Financial Condition Data

Total assets increased $15.4 million (1.7%) to $901.5 million as of June 30, 2008 from the December 31, 2007 balance of $886.1 million. Deposits increased $24.7 million (3.2%) to $801.0 million as of June 30, 2008 from the December 31, 2007 balance of $776.3 million. For the same period, net loans, which exclude loans held for sale but are net of the allowance for loan losses, increased $17.4 million (2.3%) to $786.3 million as of June 30, 2008 from the December 31, 2007 balance of $768.9 million. Commercial loans continue to be the largest segment of loans at 55.9% and 54.0% as a percentage of total loans as of June 30, 2008 and December 31, 2007, respectively.

Earnings Summary

Earnings for the three and six months ended June 30, 2008 were significantly affected by a non-cash, impairment charge of approximately $1.1 million ($723,000 net of tax) as a result of management’s determination that its $9.6 million investment in the AMF Ultra Short Mortgage Fund (the “Fund”) is other-than-temporarily impaired.

Net income was $0.27 per diluted share for the three months ended June 30, 2008 compared to $0.39 per diluted share for the three months ended June 30, 2007, a decrease of 30.8%. Net earnings for the three months ended June 30, 2008 were $1,804,000 compared to $2,627,000 for the same period in 2007, a decrease of 31.3%. Net income for the six months ended June 30, 2008 was $0.67 per diluted share compared to $0.75 per diluted share for the same period last year, a decrease of 10.7%. Net earnings for the six months ended June 30, 2008 were $4,464,000 compared to $5,000,000 for the same period in 2007, a decrease of 10.7%.

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Return on average equity for the quarter ended June 30, 2008 was 8.15% compared to 12.76% for the same period last year. Average equity increased by $6.1 million to $88.7 million for the three months ended June 30, 2008 versus $82.6 million for the same period last year. For the six months ended June 30, 2008, the Company’s return on average equity was 10.20% compared to 12.35% for the six months ended June 30, 2007. Average equity for the six months ended June 30, 2008 increased $6.4 million to $88.0 million from $81.6 million for the six months ended June 30, 2007. The Company’s capital position remains strong at 9.68% of total assets as of June 30, 2008, an increase from 9.01% at June 30, 2007.

Net Interest Income

Net interest income before provision for loan losses for the three months ended June 30, 2008 increased 3.2% to $9,389,000 from $9,102,000 for the same quarter in 2007. Net interest income before provision for loan losses for the six months ended June 30, 2008 increased 2.5% to $18,453,000 from $18,000,000 for the same period in 2007. The net interest margin (net interest income divided by average interest earning assets) increased to 4.56% for the current quarter from 4.50% for the same quarter last year. The net interest margin decreased to 4.50% for the six months ended June 30, 2008 from 4.55% for the same period in 2007.

Interest income decreased $1,651,000 or 10.6%, for the three months ended June 30, 2008 as compared to the second quarter last year and interest expense decreased $1,938,000 or 29.7%, during this same period. Interest income for the six months ended June 30, 2008 decreased $1.9 million, or 6.1%, as compared to the same period last year and interest expense decreased $2.3 million, or 18.6%, during this same period. Net loans averaged $778.0 million with an average yield of 6.98% for the three months ended June 30, 2008 compared to average net loans of $764.8 million with an average yield of 7.94% for the same period in 2007. Net loans averaged $771.7 million with an average yield of 7.21% for the six months ended June 30, 2008 compared to average net loans of $751.3 million with an average yield of 7.93% for the same period in 2007. Certificates of deposit averaged $345.3 million with an average cost of 3.64% for the three months ended June 30, 2008 compared to $350.7 million with an average cost of 4.89% for the same period in 2007. Certificates of deposit averaged $352.1 million with an average cost of 4.04% for the six months ended June 30, 2008 compared to $344.5 million with an average cost of 4.85% for the same period in 2007.

Provision for Loan Losses

The provision for loan losses was $710,000 for the three months ended June 30, 2008, an increase of $530,000 over the provision for loan losses during the second quarter of 2007. The provision for loan losses was $1,070,000 for the six months ended June 30, 2008 up $710,000 from the same period in 2007. The increase in the loss loan reserves was mostly related to management’s assessment of the increased risk in the construction loan portfolio and its current economic environment as well as increases in nonperforming loans.

Non-interest Income

Non-interest income increased 2.0% to $2,274,000 for the three months ended June 30, 2008 compared with $2,229,000 for the same quarter in 2007. Non-interest income increased 6.1% to $4,520,000 for the six months ended June 30, 2008 from $4,262,000 for same period in 2007. The increases for both the three and six month periods are the result of service charges on deposits, merchant visa income and the gain on the sale of loans mostly related to higher volumes of SBA and conventional loan sales.

Non-interest Expense

Non-interest expense increased 15.5% to $8,286,000 during the three months ended June 30, 2008 compared to $7,176,000 for the same period during 2007. Non-interest expense increased 6.2% to $15,256,000 for the six months ended June 30, 2008 from $14,362,000 for the same period last year. The increases for both the three and six month periods are the result of the $1.11 million loss on impairment of investment securities. The efficiency ratio for the quarter ended June 30, 2008 was 71.0% compared to 63.3% for the comparable quarter in 2007. The efficiency ratio for the six months ended June 30, 2008 was 66.4% compared to 64.5% for the same period last year. The increase in non-interest expense and the efficiency ratio is a result of a 1.1 million loss on impairment of investment securities. The efficiency ratio consists of non-interest expense divided by the sum of net interest income before provision for loan losses plus non-interest income.

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Lending Activities

As indicated in the table below, total loans (including loans held for sale) increased to $797.8 million at June 30, 2008 from $779.8 million at December 31, 2007.

Nonperforming Assets

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

Nonperforming assets increased to $8,456,000, or 0.94% of total assets at June 30, 2008 from $1,190,000, or 0.13% of total assets at December 31, 2007 due substantially to increases in nonperforming loans. The increase in nonperforming loans is due primarily to construction loans to two borrowers totaling $6.8 million. Given the increases in nonperforming loans, growth in our overall loan portfolio and current economic conditions we increased our allowance for loan losses to 1.41% at June 30, 2008 from 1.33% at December 31, 2007. We believe that we are adequately reserved for losses in the portfolio as of June 30, 2008. Potential problem loans are those loans that are currently accruing interest, but which are considered possible 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 and classified loan portfolio by considering a number of elements including:

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

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 at June 30, 2008 increased by $870,000 to $11.2 million from $10.4 million at December 31, 2007. Based on management’s assessment of loan quality and current economic conditions, the Company believes that its allowance for loan losses is at an appropriate level at June 30, 2008.

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.

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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 June 30, 2008, cash and cash equivalents totaled $31.1 million, and investment securities classified as either available for sale or held to maturity with maturities of one year or less amounted to $1.5 million, or 0.2% of total assets. At June 30, 2008, our banks maintained a credit facility with the FHLB of Seattle for $170.9 million, with $5.6 million in FHLB borrowings as of June 30, 2008.

Capital

Stockholders’ equity at June 30, 2008 was $87.3 million compared with $85.0 million at December 31, 2007. During the six months ended June 30, 2008, we declared dividends of $2.8 million, realized income of $4.5 million, recorded $90,000 in unrealized gains 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 $541,000.

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%. Our leverage ratio was 8.5% at June 30, 2008 compared to 8.2% at December 31, 2007. 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 10.8%, respectively, at June 30, 2008 compared with 9.5% and 10.7%, respectively, at December 31, 2007.

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 June 30, 2008.

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. Interest rate risk is measured and assessed on a quarterly basis. 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, 2007.

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.

(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 June 30, 2008.

(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 June 30, 2008, that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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, 2007.

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The Company has had various stock repurchase programs since March 1999. In August 2005, 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 295,000 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. On July 25, 2007, the Board of Directors authorized an additional eighteen month extension to this program. During the quarter ended June 30, 2008, the Company did not repurchased additional shares. In total, the Company has repurchased 169,650 shares at an average price of $22.09 under this plan.

The following table sets forth information about the Company’s purchases of its outstanding common stock during the quarter ended June 30, 2008.

None

None

None

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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.

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