Heritage Financial Announces Third Quarter 2020 Results and Declares Regular Cash Dividend

OLYMPIA, Wash., Oct. 22, 2020 /PRNewswire/ -- Heritage Financial Corporation (NASDAQ GS: HFWA) (the "Company" or "Heritage"), the parent company of Heritage Bank ("Bank"), today reported that the Company had net income of $16.6 million for the quarter ended September 30, 2020 compared to net loss of $6.1 million for the linked-quarter ended June 30, 2020 and net income of $17.9 million for the quarter ended September 30, 2019. Diluted earnings per share for the quarter ended September 30, 2020 was $0.46 compared to diluted losses per share of $0.17 for the linked-quarter ended June 30, 2020 and diluted earnings per share of $0.48 for the quarter ended September 30, 2019.

Jeffrey J. Deuel, President and Chief Executive Officer of Heritage, commented, "We are pleased with our third quarter financial performance. The overlay of COVID-19 has been difficult for everyone; however, the Heritage team has navigated these challenges and we are focused on improving our financial results and effectively managing risk. We continue to utilize technology solutions and provide digital banking for our customers, which we believe will provide opportunities to improve operating efficiencies and likewise less reliance on high-cost physical branch locations.

Further, we are pleased with our continuing efforts to have a positive impact in our local communities. We are proud to have recently been selected as the construction lender for the Vancouver Housing Authority's Plum Meadows Apartments to renovate a 16-building affordable housing community in Vancouver, Washington. In addition, we have been selected as construction lender for the Community Roots Housing's (formerly Capitol Hill Housing) renovation of the Boylston Howell, John Carney and Bremer apartments, three affordable housing projects in Seattle."

COVID-19 Response

The Company continues to be committed to supporting its community and its customers during these unprecedented times. This includes participation in the Small Business Administration's ("SBA") Paycheck Protection Program ("PPP") in accordance with the Coronavirus Aid, Relief, and Economic Security Act enacted on March 27, 2020 ("CARES Act"), as amended. Through the conclusion of the SBA's PPP on August 8, 2020, the Bank had funded 4,642 SBA PPP loans totaling $897.4 million with an average loan size of $193,000. Of the funded loans, approximately 21% of both the count and the originated balance were loans to new customers.

During the nine months ended September 30, 2020, under the CARES Act and related regulatory guidance, the Bank has accommodated loan modifications on 1,972 loans with a balance of $636.9 million at March 31, 2020. Approximately 80% of loans that obtained payment deferral modifications during the nine months ended September 30, 2020 are no longer on payment deferral status. At September 30, 2020, 260 loans totaling $117.1 million were still in payment deferral modification status, with 42% of those making interest only payments, and approximately $94.5 million, or 81%, of payment deferral modification status loans were on their second modification, generally consisting of a 90-day deferral. Loans modified under the CARES Act and related regulatory guidance are not reported as troubled-debt restructured ("TDR") loans per the enacted guidance. The Bank assesses TDR status, at a minimum, once the loan deferment period reaches 180-days.

Financial Highlights

The following table provides financial highlights at the dates and for the periods indicated:

Investment securities decreased $45.4 million, or 5.2%, to $834.5 million at September 30, 2020 from $879.9 million at June 30, 2020 primarily as a result of maturities, calls and payments of investment securities of $53.8 million, offset partially by investment purchases of $14.4 million during the quarter ended September 30, 2020.

Loans receivable, net had a nominal change in total balance at September 30, 2020 compared to June 30, 2020, but there were changes in balances by loan class. Commercial and industrial loans decreased $42.7 million and consumer loans decreased $31.0 million while non-owner occupied commercial real estate ("CRE") loans increased $33.2 million, owner-occupied CRE loans increased $21.0 million and SBA PPP loans increased $11.3 million. The decrease in commercial and industrial loans was primarily due to decreases in lines of credit balances. The utilization rate for commercial and industrial lines of credit was 23.3% and 26.2% at September 30, 2020 and June 30, 2020, respectively. The decrease in consumer loans was primarily due to the cessation of the indirect auto loan business line during the quarter ended March 31, 2020. Increases in owner-occupied CRE and non-owner occupied CRE were primarily due to originations and transfers of completed construction loans, offset partially by loans paid in full and payments on existing loans.

The following table summarizes the Company's loan portfolio by type of loan and amortized cost at the dates indicated:

Total deposits increased $121.3 million, or 2.2%, to $5.69 billion at September 30, 2020 from $5.57 billion at June 30, 2020 due primarily to increases in money market accounts of $98.1 million, or 10.0%, interest bearing demand deposits of $59.6 million, or 3.7%, and savings accounts of $20.8 million, or 4.1%, offset partially by a decrease in certificate of deposit accounts of $46.6 million, or 9.5%. The increase in total deposits was due primarily to a combination of new deposit relationships obtained in conjunction with the SBA PPP lending process and existing customers maintaining higher cash balances. Non-maturity deposits as a percentage of total deposits increased to 92.2% at September 30, 2020 from 91.2% at June 30, 2020.

The following table summarizes the Company's deposits at the dates indicated:

Total stockholders' equity increased $9.5 million, or 1.2%, to $803.1 million at September 30, 2020 from $793.7 million at June 30, 2020. Changes in stockholders' equity during the periods indicated were as follows:

During the quarter ended September 30, 2020, no shares were repurchased under the Company's stock repurchase plan as the Company halted repurchases in March 2020 (other than the cancellation of stock to pay withholding taxes on vested restricted stock awards or units) in response to the COVID-19 pandemic. As of September 30, 2020, there were 1,643,276 shares available for repurchase under the current stock repurchase plan.

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 following table summarizes capital ratios for the Company at the dates indicated:

Donald J. Hinson, Executive Vice President and Chief Financial Officer of Heritage, commented, "We continue to be pleased with our overall capital position as well as the increase in our risk-based capital ratios. We believe this capital strength, in addition to our foundation of proactive and disciplined risk management, will sustain us through the current economic conditions."

Allowance for Credit Losses

Effective January 1, 2020, the Company adopted the Financial Accounting Standard Board's Accounting Standards Update 2016-13: Financial Instruments: Credit Losses (Topic 326), as amended, and commonly referred to as "CECL," under the modified retrospective method; therefore, periods prior to the effective date are not comparable.

During the quarter ended September 30, 2020, the allowance for credit losses ("ACL") on loans increased $1.8 million, or 2.6%, to $73.3 million at September 30, 2020 due primarily to a provision for credit losses on loans of $2.3 million, offset partially by net charge-offs of $481,000 during the quarter ended September 30, 2020.

The provision for credit losses recognized during the quarter ended September 30, 2020 was primarily due to the increase in the ACL on individually evaluated loans due to the addition of loans to nonaccrual status during the current quarter, offset partially by a decrease in the ACL for loans collectively evaluated due primarily to improvements in the economic forecast. The macroeconomic forecast by Oxford Economics for the quarter ended September 30, 2020 reflected less severe magnitudes of variables, such as unemployment rate and GDP, as compared to the forecast for the linked-quarter ended June 30, 2020 as more becomes known about the impacts of COVID-19.

The Bank recognized net charge-offs of $481,000 during the quarter ended September 30, 2020 due primarily to charge-offs of two commercial and industrial loan relationships totaling $447,000 as a result of the impact of the COVID-19 pandemic. Net charge-offs were $2.0 million for the linked-quarter ended June 30, 2020 and $311,000 for the same quarter in 2019.

The following table provides detail on the changes in the ACL on loans and unfunded commitments and the related provision for credit losses for the periods indicated:

Credit Quality

Nonperforming assets increased to 0.79% of total assets at September 30, 2020 compared to 0.51% of total assets at June 30, 2020, due to an increase in nonaccrual loans. Nonperforming assets at September 30, 2020 and June 30, 2020 consist only of nonaccrual loans. Of the additions to nonaccrual loans, $19.6 million, or 94.0%, were of loans that were previously modified under the CARES Act that exhibited a continued decline in credit quality, warranting transfer to nonaccrual status. The additions include three commercial lending relationships totaling $17.4 million, comprised of a parking facility, a hotel and a group of restaurants under common ownership. The Bank is actively working with the borrowers to secure a positive resolution.

Changes in nonaccrual loans during the periods indicated were as follows:

The ACL on loans to nonaccrual loans decreased to 139.42% at September 30, 2020 compared to 212.62% at June 30, 2020 due primarily to the increase in nonaccrual loans as discussed above.

Potential problem loans are loans classified as Special Mention or worse that are not classified as a TDR or nonaccrual loan and are not individually evaluated for credit loss, but which management is closely monitoring because the financial information of the borrower causes concern as to their ability to meet their loan repayment terms. Potential problem loans increased $59.2 million, or 58.9%, to $159.8 million at September 30, 2020 compared to $100.6 million at June 30, 2020. The increase was primarily attributed to downgrades related to COVID-19, including $44.4 million of loans that were modified under the CARES Act and indicated additional signs of weakness and $23.8 million of loans that had not been modified under the CARES Act. The Bank's practice on COVID-19 related loan issues was to downgrade to a "Watch" grade if the loan was modified, unless the borrower showed strong financials or other factors indicated a less severe grade was appropriate. Loans with COVID-19 issues were classified as potential problem loans if additional factors were identified to cause a more severe grade.

Of the total additions of previously classified pass graded loans, $46.5 million were downgraded to special mention and $23.7 million were downgraded to substandard. Potential problem loan additions were offset partially by transfers of loans to nonaccrual and TDR status and net principal payments.

Changes in potential problem loans during the periods indicated were as follows:

Operating Results

Net interest income decreased $635,000, or 1.3%, to $49.7 million for the quarter ended September 30, 2020 from $50.3 million for the linked-quarter ended June 30, 2020 due primarily to sustained decreases in yields on adjustable rate instruments outpacing decreases in the cost of interest bearing liabilities, reflecting decreases in short-term market rates occurring earlier in 2020. Net interest income decreased $565,000, or 1.1%, from $50.2 million for the same period in 2019 due primarily to decreases in yields on adjustable rate instruments following several decreases in short-term market rates over the last year and the impact of the low-yielding SBA PPP loans, partially offset by decreases in the cost of interest bearing liabilities.

The federal funds target rate history since December 31, 2018 is as follows:

Net interest margin decreased 26 basis points to 3.38% for the quarter ended September 30, 2020 from 3.64% for the linked-quarter ended June 30, 2020 due primarily to decreases in the yield of interest earning assets and the change in the mix of interest earning assets, offset partially by decreases in the cost of interest bearing liabilities. Average interest earning assets increased $302.7 million, or 5.5%, from the linked-quarter due primarily to an increase in average SBA PPP loans of $195.7 million, or 29.3%, and an increase in average interest earning deposits of $204.3 million, or 110.2%. The yields on SBA PPP loans of 2.68% and interest earning deposits of 0.10% during the quarter ended September 30, 2020 are substantially lower than other interest earning assets, primarily loans. Average loans receivable, net, excluding SBA PPP loans, decreased to 63.9% of interest earning assets during the quarter ended September 30, 2020 compared to 68.0% during the linked-quarter ended June 30, 2020. This decrease, coupled with the decrease in loan yield described below, was the primary contributor to the decrease in the net interest margin. The cost of interest bearing deposits decreased 11 basis points to 0.29% during the quarter ended September 30, 2020 from 0.40% during the linked-quarter ended June 30, 2020 due primarily to the decrease in market rates.

Net interest margin decreased 83 basis points from 4.21% for the quarter ended September 30, 2019 due to similar reasons discussed above, including decreases in yields on adjustable instruments following decreases in short-term market rates, low-yielding SBA PPP loans and a significant increase in interest earning deposits combined with a 190 basis point decline in their yield from the same period in 2019, offset partially by decreases in the cost of interest bearing liabilities.

Loan yield decreased 26 basis points to 4.12% for the quarter ended September 30, 2020 from 4.38% for the linked-quarter ended June 30, 2020 due primarily to sustained decreases in short-term market rates and the negative impact to interest income due to loans transferred to nonaccrual status during the quarter ended September 30, 2020. Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans was 4.35% for the quarter ended September 30, 2020 compared to 4.56% for the linked for the linked-quarter ended June 30, 2020. The impact of nonaccrual activity on loan yield from the linked-quarter was six basis points.

Loan yield decreased 104 basis points from 5.16% for the quarter ended September 30, 2019 due primarily to the multiple and sustained decreases in short-term market rates and secondarily due to the impact of low-yielding SBA PPP loans. Loan yield, excluding SBA PPP loans and incremental accretion on purchased loans was 5.04% for the comparable quarter ended September 30, 2019. The impact of nonaccrual activity on loan yield from the prior year quarter was two basis points.

The following table presents the loan yield and the impacts of the balances and interest and fees earned on SBA PPP loans and the incremental accretion on purchased loans on this financial measure for the periods presented below:

The yield on the investment portfolio decreased 18 basis points to 2.23% for the quarter ended September 30, 2020 from 2.41% for the linked-quarter ended June 30, 2020 and decreased 48 basis points from 2.71% for the quarter ended September 30, 2019 due primarily to decreases in market interest rates impacting adjustable rate securities and lower yields on recent purchases of investment securities compared to the existing portfolio.

The cost of total deposits decreased seven basis points to 0.19% during the quarter ended September 30, 2020 from 0.26% for the linked-quarter ended June 30, 2020 primarily related to a decrease in the cost of certificates of deposit to 0.97% for the quarter ended September 30, 2020 from 1.42% for the linked-quarter ended June 30, 2020. The cost of total deposits decreased 19 basis points from 0.38% for the quarter ended September 30, 2019 due primarily to decreases in market interest rates following decreases in the federal funds target rate previously mentioned.

Provision for credit losses of $2.7 million was recorded during the quarter ended September 30, 2020, which is comprised of the estimated credit losses for loans and estimated credit losses for unfunded commitments.

The Bank recorded provision for credit losses on loans of $2.3 million during the quarter ended September 30, 2020 compared to $25.9 million during the quarter ended June 30, 2020. The provision was due primarily to increases in the ACL on individually evaluated loans that were transferred to nonaccrual status during the quarter, offset partially by a decrease in the ACL on collectively evaluated loans primarily due to modest improvements in the macroeconomic forecast described in the Allowance for Credit Losses section above. The amount of provision for credit losses on loans recorded during the quarter ended September 30, 2020 was necessary to increase the ACL on loans to an amount that management determined to be appropriate and estimated the credit losses on loans at September 30, 2020 based on its adopted CECL methodology. The provision for loan losses for the same period in 2019 was estimated under the previously utilized incurred loss methodology.

Noninterest income remained relatively constant at $8.2 million for both the quarter ended September 30, 2020 and the linked-quarter ended June 30, 2020, and decreased $248,000, or 2.9%, from $8.5 million for the same period in 2019 due primarily to a decrease in service charges and other fees of $740,000, or 15.5%. The decrease in service charges and other fees was due primarily to a decrease in overdraft fees of $561,000 from changes in customer spending habits during the COVID pandemic. The decrease in noninterest income was offset partially by an increase in gain on sale of loans of $450,000, or 45.3%, due to an increase in volume of loans sold during the quarter ended September 30, 2020 reflecting the low interest rate environment.

Noninterest expense decreased $1.0 million, or 2.8%, to $36.0 million for the quarter ended September 30, 2020 from $37.1 million for the linked-quarter ended June 30, 2020 due primarily to a decrease in professional services of $1.1 million, or 49.9%. This decrease in professional services was due to elevated expense levels in the linked-quarter ended June 30, 2020 resulting from the launch of the new mobile and online commercial banking platform, "Heritage Direct," which was completed during the quarter. Additionally, the decrease in noninterest expense was due to a decrease in compensation and employee benefits of $511,000, or 2.3%, resulting from a combination of a decrease in full-time equivalent employees, lower incentive compensation expense, and a decrease in overtime pay (elevated in the prior quarter due to the SBA PPP loan process), offset partially by a reduction of the compensation deferred as a result of lower SBA PPP origination volume during the quarter ended September 30, 2020. These decreases in noninterest expense were offset partially by an increase in federal deposit insurance premium expense of $610,000, or 256.3%, due primarily to the impact of the decrease in the Bank's Tier 1 leverage ratio on the Bank's assessment rate and the remaining usage of the Bank's small bank credit during the quarter ended June 30, 2020.

Noninterest expense decreased $674,000, or 1.8%, compared to $36.7 million for the quarter ended September 30, 2019 due primarily to a decrease in other expense of $739,000, or 26.2%, due substantially from the reduction of employee lodging, meal and travel expenses related to the Company's suspension of non-essential travel due to COVID-19; a decrease in state/municipal business and use taxes expense as a result of an assessment in the amount of $537,000 from a Washington State Department of Revenue Business and Occupation audit recognized during the quarter ended September 30, 2019; and a decrease in professional services primarily due to consulting fees recognized during the quarter ended September 30, 2019 related to CECL implementation efforts. The decrease in noninterest expense was offset partially by an increase in federal deposit insurance premium expense of $839,000 for the reasons described above and the utilization of the Bank's small bank credit for the full assessment due during the quarter ended September 30, 2019.

Income tax expense was $2.5 million for the quarter ended September 30, 2020 compared to income tax benefit of $936,000 for the linked-quarter ended June 30, 2020 and income tax expense of $3.6 million for the quarter ended September 30, 2019. The effective tax rate was 13.0% for the quarter ended September 30, 2020 compared to an effective tax benefit rate of 13.2% for the linked-quarter ended June 30, 2020 and an effective tax rate of 16.8% for the quarter ended September 30, 2019. The decrease in the effective tax rate from the quarter ended September 30, 2019 was due to the year-over-year decrease in estimated annual pre-tax income which results in an increased impact of favorable permanent tax items such as tax-exempt investments, investments in bank owned life insurance and low-income housing tax credits.

Branch Consolidation Plan

After careful consideration and analysis, the Company has decided to consolidate nine branches to create a more efficient branch footprint, including one branch during October 2020 and eight branches during January 2021. This is a decrease of 15% in the number of total branches and will reduce the branch count from 62 to 53. The Company plans to integrate these locations into other branches within its network. These actions are a result of the Company's increased focus on balancing physical locations and digital banking channels, driven by increased client usage of online and mobile banking and a commitment to improve digital banking technology.

The Company anticipates annual expense savings of approximately $2.3 million as a result of these consolidations. The Company expects to incur total pre-tax expense related to the consolidations of $1.6 million.

Dividends

On October 21, 2020, the Company's Board of Directors declared a quarterly cash dividend of $0.20 per share. The dividends are payable on November 18, 2020 to shareholders of record as of the close of business on November 4, 2020.

Earnings Conference Call

The Company will hold a telephone conference call to discuss this earnings release on October 22, 2020 at 11:00 a.m. Pacific time. To access the call, please dial (844) 721-7241 -- access code 348422 a few minutes prior to 11:00 a.m. Pacific time. The call will be available for replay through November 5, 2020 by dialing (866) 207-1041 -- access code 4372884.

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 62 banking offices in Washington and Oregon. Heritage Bank does business 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. 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. These non-GAAP measures have inherent limitations, are not required to be uniformly applied and are not audited. They should not be considered in isolation or as a substitute for total stockholders' equity or operating results determined in accordance with GAAP. These non-GAAP measures may not be comparable to similarly titled measures reported by other companies. 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. The COVID-19, pandemic is adversely affecting us, our customers, counterparties, employees, and third-party service providers, and the ultimate extent of the impacts on our business, financial position, results of operations, liquidity, and prospects is uncertain. Continued deterioration in general business and economic conditions, including further increases in unemployment rates, or turbulence in domestic or global financial markets could adversely affect our revenues and the values of our assets and liabilities, reduce the availability of funding, lead to a tightening of credit, and further increase stock price volatility. In addition, changes to statutes, regulations, or regulatory policies or practices as a result of, or in response to COVID-19, could affect us in substantial and unpredictable ways. Other factors that could cause or contribute to such differences include, but are not limited to: 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 2020 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.