Heritage Financial Announces Fourth Quarter And Annual 2017 Results And Declares Regular Cash Dividend

OLYMPIA, Wash., Jan. 25, 2018 /PRNewswire/ -- Heritage Financial Corporation (NASDAQ GS: HFWA) (the "Company" or "Heritage") today reported that the Company had net income of $7.0 million for the quarter ended December 31, 2017 compared to $9.9 million for the quarter ended December 31, 2016 and $10.6 million for the linked-quarter ended September 30, 2017. Diluted earnings per common share for the quarter ended December 31, 2017 was $0.23 compared to $0.33 for the quarter ended December 31, 2016 and $0.35 for the linked-quarter ended September 30, 2017.

The Company had net income of $38.8 million for the year ended December 31, 2017, or $1.29 per diluted common share, compared to $38.9 million, or $1.30 per diluted common share, for the year ended December 31, 2016.

The current quarter results were impacted by the Tax Cuts and Jobs Act enacted December 22, 2017, which required a revaluation of our deferred tax assets and liabilities to account for the future impact of the decrease in corporate tax rate to 21% from 35% and other provisions of the legislation. As a result of our estimated revaluation of the net deferred tax asset, income tax expense increased $5.6 million, which reduced net income by $0.19 per diluted share for the quarter and year ended December 31, 2017. Certain amounts of the revaluation are considered reasonable estimates of the impact of the legislation as of December 31, 2017. As a result, the amounts could be adjusted during the measurement period, which will end in December 2018.

Brian L. Vance, President and CEO, commented, "We are pleased with our overall performance for 2017.  We achieved some important milestones this past year.  During 2017, we surpassed the $4.0 billion mark in total assets; we set all-time highs in our stock price; Heritage Bank celebrated its 90^th anniversary and the Company celebrated 20 years of being listed on Nasdaq by ringing the opening bell on January 9, 2018; we announced the hiring of a new team of bankers in Portland, Oregon; and we entered into a merger agreement with Puget Sound Bancorp, Inc. (our 6^th acquisition since 2010) which we closed on January 16, 2018.

We are also pleased with our financial performance during the year where we posted annual loan growth of 7.9%; we continued improvement in our overhead ratio that culminated with an overhead ratio of 2.66% during the 4^th quarter of 2017; and, even with an unfavorable impact of $0.19 per share related to the estimated revaluation of net deferred tax assets in 2017, we recognized diluted earnings per share of $1.29 in 2017 compared to $1.30 in 2016."

Acquisition of Puget Sound Bancorp, Inc.
On January 16, 2018, the Company completed the acquisition of Puget Sound Bancorp, Inc. ("Puget Sound"), the holding company for Puget Sound Bank, both of Bellevue, Washington ("Puget Sound Merger").  Pursuant to the terms of the merger agreement, Puget Sound shareholders received 1.1688 shares of Heritage common stock per share of Puget Sound stock at the per share, closing date price on January 12, 2018 of $31.80. Heritage issued an aggregate of 4.1 million shares of its common stock in the transaction. As of the acquisition date, Puget Sound merged into Heritage and Puget Sound Bank merged into Heritage Bank. As of December 31, 2017, Puget Sound had $556.0 million in total assets, $388.3 million in total loans and $491.9 million in total deposits. Costs incurred by Heritage for the Puget Sound Merger totaled $423,000 and $810,000 during the quarter and year ended December 31, 2017, respectively.

Balance Sheet
The Company's total assets increased $60.2 million, or 1.5%, to $4.11 billion at December 31, 2017 from $4.05 billion at September 30, 2017.

Total loans receivable, net of allowance for loan losses, increased $50.9 million, or 1.8%, to $2.82 billion at December 31, 2017 from $2.77 billion at September 30, 2017. The growth in loans receivable was due primarily to increases in non-owner occupied commercial real estate loans of $56.4 million, owner-occupied commercial real estate loans of $19.9 million and consumer loans of $14.4 million, offset partially by decreases in real estate construction and land development loans of $24.9 million and commercial and industrial loans of $20.2 million. Total loans receivable, net of allowance for loan losses, increased $207.3 million, or 7.9%, from $2.61 billion at December 31, 2016.  The year-over-year loan growth was primarily a result of increases in non-owner occupied commercial real estate loans of $105.7 million, owner-occupied commercial real estate loans of $64.1 million and consumer loans of $30.0 million during the year ended December 31, 2017.

Prepaid expenses and other assets increased $8.6 million, or 9.8%, to $96.3 million at December 31, 2017 from $87.7 million at September 30, 2017 primarily as a result of the Company's investment in two new low income housing tax credit partnerships totaling $18.9 million during the quarter ended December 31, 2017. These investments had corresponding obligations recorded in accrued expenses and other liabilities of $18.9 million at December 31, 2017. These obligations will decrease as projects in the partnerships are funded. During the quarter ended December 31, 2017, the Company made capital contributions related to other low income housing tax credit partnerships of $3.0 million, partially offsetting the increase in accrued expenses and other liabilities.

The increase in prepaid expenses and other assets was partially offset by a decrease in deferred tax assets of $9.2 million, of which $5.6 million was due to the impact of the Tax Cuts and Jobs Act.  The estimated revaluation of net deferred tax asset of $5.6 million was recorded as federal income tax expense during the quarter ended December 31, 2017 and increased the effective tax rate for the quarter by 32.2% to 59.4%.

Total deposits increased $72.2 million, or 2.2%, to $3.39 billion at December 31, 2017 from $3.32 billion at September 30, 2017 primarily due to increases in noninterest bearing demand deposits of $28.5 million, or 3.1%, interest bearing demand deposit accounts of $20.3 million, or 2.0%, money market accounts of $18.7 million, or 3.9%, and certificates of deposit of $3.2 million, or 0.8%. Non-maturity deposits as a percentage of total deposits increased slightly to 88.3% as of December 31, 2017 from 88.1% as of September 30, 2017 due to a higher proportional increases of total non-maturity deposits compared to increases in certificates of deposit accounts.

Total stockholders' equity decreased $2.3 million, or 0.5%, to $505.3 million at December 31, 2017 from $507.6 million at September 30, 2017. The decrease was primarily due to cash dividends declared of $6.9 million and an other comprehensive loss of $2.9 million related to net unrealized losses recorded during the quarter due to rising interest rates that negatively impacted our bond portfolio, offset partially by net income of $7.0 million. The ratio of tangible common equity to tangible assets decreased to 9.5% at December 31, 2017 from 9.7% at September 30, 2017. The Company and Heritage Bank continue to maintain capital levels in excess of the applicable regulatory requirements for them to be categorized as "well-capitalized". The Company had common equity Tier 1 risk-based, Tier 1 leverage, Tier 1 risk-based and total risk-based capital ratios of 11.2%, 10.1%, 11.8% and 12.7%, respectively, at December 31, 2017, compared to 11.4%, 10.4%, 12.0% and 13.0%, respectively, at September 30, 2017 and 11.4%, 10.3%, 12.0% and 13.0%, respectively at December 31, 2016.

Credit Quality
The allowance for loan losses increased $686,000, or 2.2%, to $32.1 million for the quarter ended December 31, 2017 from $31.4 million for the linked-quarter ended September 30, 2017. The increase was due primarily to provision for loan losses of $1.3 million primarily as a result of loan growth, offset partially by net charge-offs of $652,000 during the quarter ended December 31, 2017. The allowance for loan losses increased $1.0 million, or 3.2%, from $31.1 million at December 31, 2016 due to a provision for loan losses of $4.2 million partially offset by net charge-offs of $3.2 million recognized during the year ended December 31, 2017.

Nonperforming loans to loans receivable, net, decreased to 0.38% at December 31, 2017 from 0.39% at September 30, 2017 and decreased from 0.41% at December 31, 2016. Nonaccrual loans decreased $249,000, or 2.3%, to $10.7 million ($1.2 million guaranteed by government agencies) at December 31, 2017 from $11.0 million ($2.5 million guaranteed by government agencies) at September 30, 2017 and decreased $206,000, or 1.9%, from $10.9 million ($2.8 million guaranteed by government agencies) at December 31, 2016. Linked-quarter activity in nonaccrual loans included net principal reductions of $936,000, a transfer of one loan to accruing status of $767,000 and charge-offs of $469,000, offset partially by additions to nonaccrual loans of $1.9 million, of which $478,000 were loans previously classified as performing troubled debt restructured loans. Year to date activity in nonaccrual loans included net principal reductions of $6.2 million and charge-offs of $1.2 million, offset partially by additions to nonaccrual loans of $7.2 million, of which $3.3 million and $1.6 million were previously potential problem loans and troubled debt restructured loans, respectively.

The allowance for loan losses to nonperforming loans was 299.79% at December 31, 2017 compared to 286.71% at the linked-quarter ended September 30, 2017 and 284.93% at December 31, 2016.

Potential problem loans were $83.5 million at December 31, 2017 compared to $84.1 million at September 30, 2017 and $87.8 million at December 31, 2016. The $546,000, or 0.6%, decrease from the linked-quarter was primarily due to net loan payments of $18.7 million, transfer of loans to nonaccrual status of $1.4 million, loan grade improvements of $866,000 and charge-offs of $174,000, offset partially by additions of loans graded as potential problem loans of $20.6 million.

The allowance for loan losses to loans receivable, net, increased to 1.13% at December 31, 2017 from 1.12% at September 30, 2017 and decreased from 1.18% at December 31, 2016. The Company believes that its allowance for loan losses is appropriate to provide for probable incurred credit losses based on an evaluation of known and inherent risks in the loan portfolio at December 31, 2017. Included in the carrying value of loans are net discounts on loans purchased in mergers and acquisitions which may reduce the need for an allowance for loan losses on these loans because they are carried at an amount below the outstanding principal balance. The remaining net discounts on these purchased loans was $10.1 million at December 31, 2017 compared to $11.7 million at September 30, 2017 and $13.5 million at December 31, 2016.

Net charge-offs were $652,000 for the quarter ended December 31, 2017 compared to net charge-offs of $305,000 for the same quarter in 2016 and net charge-offs of $2.2 million for the linked-quarter ended September 30, 2017.  The decrease in net charge-offs compared to the linked-quarter was due to charge-offs of $1.5 million recorded during third quarter 2017 related to the closure of a purchased credit impaired pool of commercial real estate loans, representing past residual losses estimated and provided for in the pool's allocated allowance for loan losses.  Net charge-offs for the year ended December 31, 2017 were $3.2 million compared to net charge-offs of $3.6 million for the year ended December 31, 2016, which included PCI pool closure charge-offs of $1.7 million and $1.0 million, respectively.

Nonperforming assets decreased $772,000, or 6.7%, to $10.7 million ($1.2 million guaranteed by government agencies), or 0.26% of total assets, at December 31, 2017, compared to $11.5 million ($2.5 million guaranteed by government agencies), or 0.28% of total assets, at September 30, 2017, due primarily to the decrease in nonaccrual loans explained above. In addition, during the quarter ended December 31, 2017, the Bank sold its one remaining property in other real estate owned (totaling $523,000 as of September 30, 2017), resulting in a gain on sale of $33,000. Nonperforming assets decreased $1.0 million, or 8.2%, from December 31, 2016 as a result of the decrease in nonaccrual loans explained above as well as the sale of other real estate owned properties totaling $754,000 at December 31, 2016 for a gain on sale of $144,000.

Operating Results
Net interest income increased $4.2 million, or 12.6%, to $37.2 million for the quarter ended December 31, 2017 compared to $33.1 million for the same period in 2016 and increased $2.2 million, or 6.4%, from $35.0 million for the linked-quarter ended September 30, 2017. Net interest income increased $7.0 million, or 5.3%, to $139.5 million for the year ended December 31, 2017 compared to $132.5 million for the year ended December 31, 2016. The increases in net interest income for all periods noted were primarily due to increases in average interest earning assets and yields on interest earning assets.

Heritage's net interest margin for the quarter ended December 31, 2017 increased 17 basis points to 4.02% from 3.85% for both the same period in 2016 and the linked-quarter ended September 30, 2017 due primarily to higher incremental accretion on purchased loans compared to prior periods. The net interest margin for the year ended December 31, 2017 decreased four basis points to 3.92% from 3.96% for the same period in 2016 primarily due to a decrease in the loan yields, which is included in the table below.

The loan yield, excluding incremental accretion on purchased loans, increased to 4.55% for the quarter ended December 31, 2017 compared to 4.49% for the quarter ended December 31, 2016 because of an increase in variable indexed contractual note rates in the loan portfolio.  While variable indexed rates had increased quarter-over-quarter, the loan yield, excluding incremental accretion on purchased loans, decreased two basis points to 4.55% for the quarter ended December 31, 2017 from 4.57% for the linked-quarter ended September 30, 2017 due primarily to a four basis point impact of larger nonaccrual loan payoffs, including back interest, recorded during the quarter ended September 30, 2017 and a one basis point impact of reversing accrued interest income for new nonaccrual loans added during the quarter ended December 31, 2017.  The Bank also had a slight increase in fixed rate loans as a percentage of total loans with lower contractual note rates compared to variable rate loans during the quarter ended December 31, 2017 as compared to the linked-quarter, which offset the impact from the variable rate increases.

Loan yield, excluding incremental accretion on purchased loans, decreased seven basis points to 4.55% for the year ended December 31, 2017 compared to 4.62% for the year ended 2016 due primarily to a combination of lower consumer indirect loan yields during 2017, fewer payments in 2017 to resolve nonperforming or charged-off loans and lower prepayment penalties received in 2017 as compared to 2016.

Impact on loan yield from incremental accretion on purchased loans increased 23 basis points to 0.38% for the quarter ended December 31, 2017 compared to 0.15% for the linked-quarter ended September 30, 2017 and increased 15 basis points from 0.23% for the comparative quarter ended December 31, 2016 primarily due to incremental accretion of $1.8 million related to two significant nonperforming PCI loans which paid in full during the quarter ended December 31, 2017.

Incremental accretion decreased $835,000, or 11.7%, to $6.3 million for the year ended December 31, 2017 from $7.2 million for the same period in 2016. The incremental accretion and the impact to loan yield will change during any quarter based on the volume of prepayments, but is expected to decrease over time as the balance of the purchased loans continues to decrease.

The following table presents the net interest margin, loan yield and the effect of the incremental accretion on purchased loans on these ratios for the periods presented below:

Donald J. Hinson, Executive Vice President and Chief Financial Officer, commented, "As stated above, incremental accretion was elevated in the most recent quarter due mostly to a couple of large prepayments of previously purchased credit impaired loans.  We do not expect this level of incremental accretion to continue into the future."

"We are experiencing overall benefits to the loan yield from an upwardly shifting yield curve.  The weighted average note rate on new loans originated during quarter ended December 31, 2017 increased to 4.58% from 4.45% for the quarter ended September 30, 2017 and from 4.08% for the quarter ended December 31, 2016.  It is expected that this trend of increasing rates on originated loans will result in higher pre-accretion loan yields in future periods."

In addition to loan yields, also impacting net interest margin were increases in the yields on investment securities in 2017 as compared to the 2016 periods. The yield on the aggregate investment portfolio increased to 2.29% for the quarter ended December 31, 2017 compared to 1.96% for the quarter ended December 31, 2016 and 2.24% for the linked-quarter ended September 30, 2017 and increased to 2.25% for the year ended December 31, 2017 compared to 1.98% for the same period in 2016, primarily reflecting the effect of the rise in interest rates on our adjustable rate investment securities.

The average balance and cost of interest bearing liabilities additionally has impacted net interest margin, both including and excluding incremental accretion on purchased loans. Most significantly, the average balance of FHLB and other borrowings increased to $103.0 million during the quarter ended December 31, 2017 compared to $18.5 million during the same period in 2016.  The average balance of FHLB and other borrowings decreased from $111.3 million during the linked-quarter ended September 30, 2017. The cost of total interest bearing liabilities increased to 0.37% during the quarter ended December 31, 2017 compared to 0.25% for the quarter ended December 31, 2016 and 0.36% for the linked-quarter ended September 30, 2017. The cost of interest bearing liabilities increased to 0.33% for the year ended December 31, 2017 compared to 0.25% for the same period in 2016. The increases in costs from prior periods was primarily a result of the increased use of higher cost borrowings to fund asset growth, and to a lesser extent, increases in market interest rates.

The provision for loan losses increased $161,000, or 13.7%, to $1.3 million for the quarter ended December 31, 2017 compared to $1.2 million for the quarter ended December 31, 2016 and increased $454,000, or 51.4%, from the linked-quarter ended September 30, 2017. The provision for loan losses decreased $711,000, or 14.4%, to $4.2 million for the year ended December 31, 2017 compared to $4.9 million at December 31, 2016. The amount of provision for loan losses was necessary to increase the allowance for loan losses to an amount that management determined to be appropriate at December 31, 2017 based on the use of a consistent methodology. The decrease in the provision for loan losses from the prior year primarily reflects continued improvements in our asset quality, changes in volume and mix of loans, changes in certain environmental factors and improvements in certain historical loss factors partially offset by the impact of loan growth.

Noninterest income increased $816,000, or 10.0%, to $9.0 million for the quarter ended December 31, 2017 compared to $8.2 million for the same period in 2016 and increased $608,000, or 7.2%, from $8.4 million for the linked-quarter ended September 30, 2017. The increases from the prior periods were due primarily to increases in other income, including $682,000 in net gain on sales of two former Heritage Bank branches held for sale recognized during the quarter ended December 31, 2017 and increases in recoveries of zero balance purchased loan notes which were charged-off prior to the consummation of the related acquisition. The increase in noninterest income for the quarter ended December 31, 2017 compared to the quarter ended December 31, 2016 was partially offset by decreases in gain on sale of loans and interest rate swap fees due to decreases in the amount of loans sold and in the number of swaps executed during the current quarter.

Noninterest income increased $3.8 million, or 12.0%, to $35.4 million for the year ended December 31, 2017 compared to $31.6 million for the same period in 2016 primarily due to an increase in service charges and other fees of $3.7 million, or 25.4%, due primarily to an increase in deposit balances and changes in fee structures on deposit accounts and increases in other income explained above, offset partially by a decrease in gain on sale of investments as a result of fewer sales during 2017.

Noninterest expense increased $779,000, or 2.9%, to $27.6 million for the quarter ended December 31, 2017 compared to $26.8 million for the same period in 2016. Noninterest expense increased $4.1 million, or 3.9%, to $110.6 million for the year ended December 31, 2017 compared to $106.5 million for the same period in 2016. The increases from the 2016 periods were primarily due to increases in compensation and employee benefits which were mainly a result of senior level staffing increases, standard salary increases, and costs related to the addition of the new Portland, Oregon lending team members who started in May 2017.  Increases in noninterest expense in 2017 periods as compared to 2016 periods were also due to increases in professional services and data processing as a result of the merger costs relating to the previously mentioned Puget Sound Merger.

Noninterest expense decreased $367,000, or 1.3%, from $28.0 million for the linked-quarter ended September 30, 2017 primarily as a result of a decrease in marketing expense during the quarter. 

The ratio of noninterest expense to average assets (annualized) was 2.66% for the quarter ended December 31, 2017 compared to 2.78% for the same period in 2016 and 2.76% for the linked-quarter ended September 30, 2017. The ratio of noninterest expense to average assets was 2.78% for year ended December 31, 2017 compared to 2.84% for the year ended December 31, 2016.

Jeffrey J. Deuel, President and Chief Operating Officer of Heritage Bank, commented, "It is good to see the positive progress brought about by many of the strategic initiatives we have been focused on over the past few years as well as the ongoing development of our enterprise risk platform, the addition of our new Chief Technology Officer, the build-out of the new Portland platform and the enhancement of our King County presence with the addition of the Puget Sound Bank team."

Income tax expense was $10.3 million for the quarter ended December 31, 2017 compared to $3.4 million for the quarter ended December 31, 2016 and $3.9 million the linked-quarter ended September 30, 2017. Income tax expense was $21.4 million for the year ended December 31, 2017 compared to $13.8 million for the year ended December 31, 2016. The increase in income tax expense during the quarter and year ended December 31, 2017 was due primarily to the impact of the estimated revaluation of the net deferred tax asset as a result of the Tax Cuts and Jobs Act discussed above, resulting in the recognition of $5.6 million of additional tax expense, in addition to higher pre-tax net income.

The effective tax rate was 59.4% for the quarter ended December 31, 2017 compared to 25.4% for the comparable quarter in 2016 and 27.0% for the linked-quarter ended September 30, 2017. The effective tax rate was 35.5% for the year ended December 31, 2017 compared to 26.2% for the year ended December 31, 2016. The increase in the effective tax rates for the quarter and year ended December 31, 2017 was due primarily to the estimated revaluation of the net deferred tax asset as a result of the Tax Cuts and Jobs Act and a lower proportion of tax-exempt income to total pre-tax income.

Dividends
On January 24, 2018, the Company's Board of Directors declared a quarterly cash dividend of $0.15 per common share. The dividend is payable on February 21, 2018 to shareholders of record as of the close of business on February 7, 2018.

Earnings Conference Call
The Company will hold a telephone conference call to discuss this earnings release on January 25, 2018 at 11:00 a.m. Pacific time. To access the call, please dial (800) 230-1074 a few minutes prior to 11:00 a.m. Pacific time. The call will be available for replay through February 8, 2018, by dialing (800) 475-6701 -- access code 442448.

About Heritage Financial
Heritage Financial Corporation is an Olympia-based bank holding company with Heritage Bank, a full-service commercial bank, as its sole wholly-owned banking subsidiary. Heritage Bank has a branching network of 60 banking offices in Washington and Oregon. Heritage Bank does business under the Central Valley Bank name in the Yakima and Kittitas counties of Washington and under the Whidbey Island Bank name on Whidbey Island. Heritage's stock is traded on the NASDAQ Global Select Market under the symbol "HFWA". More information about Heritage Financial Corporation can be found on its website at www.hf-wa.com and more information about Heritage Bank can be found on its website at www.heritagebanknw.com.

Non-GAAP Financial Measures
This news release contains certain non-GAAP (Generally Accepted Accounting Principles) financial measures in addition to results presented in accordance with GAAP. These measures include tangible common stockholders' equity, tangible book value per share and tangible common stockholders' equity to tangible assets. Tangible common stockholders' equity (tangible book value) excludes goodwill and other intangible assets. Tangible assets exclude goodwill and other intangible assets. Management has presented these non-GAAP financial measures in this earnings release because it believes that they provide useful and comparative information to assess trends in the Company's capital reflected in the current quarter and year-to-date results and facilitate comparison of our performance with the performance of our peers. Where applicable, the Company has also presented comparable earnings information using GAAP financial measures. Reconciliations of the GAAP and non-GAAP financial measures are presented below.

Forward-Looking Statements
This press release includes "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements often include words such as "believe," "expect," "anticipate," "estimate," and "intend" or future or conditional verbs such as "will," "would," "should," "could," or "may." Forward-looking statements are not historical facts but instead represent management's current expectations and forecasts regarding future events, many of which are inherently uncertain and outside of our control. Actual results may differ, possibly materially, from those currently expected or projected in these forward-looking statements. Factors that could cause our actual results to differ materially from those described in the forward-looking statements, include the expected revenues, cost savings, synergies and other benefits from the Puget Sound merger might not be realized within the expected time frames or at all, and costs or difficulties relating to integration matters, including but not limited to, customer and employee retention might be greater than expected; increased competitive pressures; changes in the interest rate environment; changes in general economic conditions and conditions within the securities markets; legislative and regulatory changes; and other factors described in Heritage's latest annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other documents filed with or furnished to the Securities and Exchange Commission-which are available on our website at www.heritagebanknw.com and on the SEC's website at www.sec.gov. The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, any of the forward-looking statements that we make in this press release or the documents we file with or furnish to the SEC are based only on information then actually known to the Company and upon management's beliefs and assumptions at the time they are made which may turn out to be wrong because of inaccurate assumptions we might make, because of the factors described above or because of other factors that we cannot foresee. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for 2017 and beyond to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company's operating and stock price performance.