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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
[X] Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the fiscal year ended December 31, 1999
[_] Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
Commission File No. 0-29480
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HERITAGE FINANCIAL CORPORATION
(Exact name of registrant as specified in its charter)
Washington 91-1857900
(State or other jurisdiction (IRS Employer
of incorporation or organization) Identification No.)
201 Fifth Avenue SW, Olympia, Washington 98501
(Address of principal executive offices, including zip code)
Registrant's telephone number, including area code: (360) 943-1500
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, no par value per share
(Title of class)
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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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of the voting stock held by non-affiliates of the
registrant is $65,603,146 and is based upon the last sales price as quoted on
the NASDAQ Stock Market for March 8, 2000.
The Registrant had 9,771,546 shares of common stock outstanding as of March
8, 2000.
DOCUMENTS TO BE INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement dated March 22, 2000
for the 2000 Annual Meeting of Stockholders will be incorporated by reference
into Part III of this Form 10-K.
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HERITAGE FINANCIAL CORPORATION
FORM 10-K
December 31, 1999
INDEX
Page
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PART 1
ITEM 1. BUSINESS...................................................... 3
LENDING ACTIVITIES............................................ 4
INVESTMENT ACTIVITIES......................................... 11
DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS................. 14
SUPERVISION AND REGULATION.................................... 17
COMPETITION................................................... 21
ITEM 2. PROPERTIES.................................................... 21
ITEM 3. LEGAL PROCEEDINGS ............................................ 22
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 22
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS...................................................... 23
ITEM 6. SELECTED FINANCIAL DATA....................................... 24
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS.................................... 25
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.... 38
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................... 39
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURES.................................... 39
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............ 40
ITEM 11. EXECUTIVE COMPENSATION........................................ 40
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT................................................... 40
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................ 40
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM
10-K.......................................................... 41
2
ITEM 1. BUSINESS
General
Heritage Financial Corporation, Inc. is a bank holding company incorporated
in the State of Washington in August 1997. We were organized for the purpose
of acquiring all of the capital stock of Heritage Bank upon our reorganization
from a mutual holding company form of organization to a stock holding company
form of organization (the "Conversion").
We are primarily engaged in the business of planning, directing and
coordinating the business activities of our wholly owned subsidiaries:
Heritage Savings Bank and Central Valley Bank, N.A. Heritage Bank is a
Washington-chartered savings bank whose deposits are insured by the Federal
Deposit Insurance Corporation (FDIC) under the Savings Association Insurance
Fund (SAIF). Heritage Bank conducts business from its main office in Olympia,
Washington and its eleven branch offices located in Thurston, Pierce and Mason
Counties. Central Valley Bank is a National Bank whose deposits are insured by
the FDIC under the Bank Insurance Fund (BIF). Central Valley Bank conducts
business from its main office in Toppenish, Washington, and its four branch
offices located in Yakima County.
Our business consists primarily of focusing on 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.
On March 5, 1999, we merged with Washington Independent Bancshares, Inc.
whose wholly owned subsidiary was Central Valley Bank. In that merger we
exchanged 1,058,009 shares of our common stock for all of the outstanding
shares of Washington Independent common stock. This merger was accounted for
as a pooling of interests and accordingly, our financial information reported
herein has been restated to include the accounts and results of operations of
Washington Independent for all periods presented. Effective June 12, 1998, we
acquired North Pacific Bank, a Washington-chartered commercial bank, which was
merged into Heritage Bank effective November 20, 1998.
Effective with the year ending December 31, 1998 we changed our fiscal year
end from June 30th to December 31st. On December 31, 1998, we filed a
Transition Report Form 10-K with the SEC reporting for the six month period
ended December 31, 1998. This filing of Form 10-K for the fiscal year ended
December 31, 1999 will be the first full twelve month period filed with a
calendar year ending. Throughout this report every effort has been made to
clarify the accounting period being referenced (i.e. six months ending
December 31, 1998 or year ending June 30, 1998 etc.) and when appropriate year
to year comparisons are made that reflect equivalent twelve month periods
(i.e. twelve months ending December 31, 1998 to twelve months ending December
31, 1999).
Market Areas
We offer financial services to meet the needs of the communities we serve
through community-oriented financial institutions. Headquartered in Olympia,
Thurston County, Washington, we conduct business through Heritage Bank from
twelve full service offices, six in Pierce County, five in Thurston County and
one in Mason County. Heritage Bank has two mortgage origination offices, one
in Thurston County and one in Pierce County, both of which operate within
banking offices. We service Yakima County through Central Valley Bank from
their headquarters in Toppenish, Washington, using five branch offices.
Olympia enjoys a stable economic climate, largely due to government
employment and military personnel (Fort Lewis and McChord Air Force Base are
both located in our primary market area), both retired and active. State
government is by far the largest employer in Thurston County, employing over
40% of the total county work force. Federal, county and municipal government
together comprise nearly 50% of the county's civilian employment base.
3
Thurston County has a population of 202,700 as of April 1, 1999 and was one
of the fastest growing metropolitan counties in the state of Washington as
reported by the State Department of Natural Resources. Thurston County's
growth has been spurred by increased government employment and the expansion
of a large retirement population, including many former military personnel.
Pierce County, where Tacoma is located, has an official population of
700,000 according to the state Office of Financial Management. Its economy is
well-diversified, with the principal industries being aerospace, shipping,
military-related government employment, agriculture and forest products.
Our market area also includes Shelton and the surrounding Mason County area.
The population of Mason county was approximately 48,600 in 1999, and its
economy is substantially dependent upon the timber and forest products
industries.
Yakima County is located in central Washington. It has a population of
204,000, and its economy is substantially dependent upon agriculture. Yakima
County boasts the highest production of apples and hops of any county in the
nation.
Lending Activities
General. Our lending activities are carried on through the two banks,
Heritage Bank and Central Valley Bank. We traditionally have originated one-
to four-family residential mortgage loans and, to a lesser extent,
multifamily, commercial real estate, construction, and agricultural loans. In
the fiscal year ended June 30, 1994, we implemented a growth strategy intended
to broaden our products and services from traditional thrift products and
services to those more closely related to commercial banking. In this regard,
during this period, we began to emphasize relationship banking and to expand
our business lending capabilities. Beginning in 1996, Heritage Bank began
hiring commercial loan officers, experienced in the Puget Sound region. The
loan officers, in addition to bringing to us previous customer relationships,
have taken advantage of the opportunity to attract customers of banks that
have been acquired via mergers with out-of-area institutions. In June 1998, we
completed our acquisition of North Pacific Bank, a $84.9 million asset
commercial bank. In March 1999, we merged with Washington Independent
Bancshares, holding company for Central Valley Bank NA, a $61 million
commercial bank. These combinations accelerated our expansion of our
commercial banking focus. Taken together, these efforts contributed to an
increase in commercial loans to $192.1 million, or 46.0% of total loans, as of
December 31, 1999 from $128.2 million, or 39.2% of total loans, as of December
31, 1998. As we pursue our strategy, management is continuing to emphasize
strong asset quality.
Our overall lending operations are guided by loan policies which are
reviewed and approved annually by our board of directors, and which outline
the basic policies and procedures by which lending operations are conducted.
Generally, the policies address the types of loans, underwriting and
collateral requirements, terms, interest rate and yield considerations, and
compliance with laws and regulations in addition to establishing internal
lending limits. We supplement our own supervision of the loan underwriting and
approval process with periodic loan audits by experienced external loan
specialists who review credit quality, loan documentation and compliance with
laws and regulations.
4
The following table sets forth at the dates indicated our loan portfolio by
type of loan. These balances are net of deferred loan fees and prior to
deduction for the allowance for loan losses.
At June 30, At December 31,
---------------------------------------------------- ----------------------------------
1996 1997 1998 1998 1999
---------------- ---------------- ---------------- ---------------- ----------------
% of % of % of % of % of
Balance Total Balance Total Balance Total Balance Total Balance Total
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
(Dollars in thousands)
Commercial.............. $ 30,913 15.54% $ 53,994 22.22% $117,655 37.46% $128,171 39.20% $192,088 45.98%
Real Estate Mortgages
One-four family
residential (1)....... 96,294 48.41 107,010 44.02 100,753 32.07 97,277 29.76 97,907 23.44
Five or more family
residential and
commercial
properties............ 55,658 27.98 66,260 27.26 72,406 23.05 70,139 21.45 94,242 22.56
Total real estate
mortgages............. 151,952 76.39 173,270 71.28 173,159 55.12 167,416 51.21 192,149 46.00
Real estate construction
One-four family
residential........... 14,840 7.46 13,142 5.41 19,505 6.21 26,640 8.15 23,293 5.58
Five or more family
residential and
commercial
properties............ 393 0.20 1,029 0.42 527 0.17 2,123 0.65 7,537 1.80
Total real estate
construction (2)...... 15,233 7.66 14,171 5.83 20,032 6.38 28,763 8.80 30,830 7.38
Consumer................ 1,900 0.96 2,692 1.11 4,477 1.43 4,000 1.22 4,273 1.02
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total loans............ 199,998 100.55% 244,127 100.44% 315,323 100.39% 328,351 100.43% 419,340 100.38%
Less deferred loan fees
and other.............. (1,090) -0.55 (1,079) -0.44 (1,228) -0.39 (1,400) -0.43 (1,578) -0.38%
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Net loans.............. $198,908 100.00% $243,048 100.00% $314,095 100.00% $326,951 100.00% $417,762 100.00%
======== ====== ======== ====== ======== ====== ======== ====== ======== ======
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(1) Includes loans held for sale of $5,286, $6,323, $6,411, $7,618, and $589,
respectively.
(2) Balances are net of undisbursed loan proceeds.
The following table presents at December 31, 1999, (i) the aggregate
maturities of loans in the named categories of our loan portfolio and (ii) the
aggregate amounts of fixed rate and variable or adjustable rate loans in the
named categories that mature after one year.
Maturing
---------------------------------
Within 1-5 After
1 year years 5 years Total
------- ------- -------- --------
(Dollars in thousands)
Commercial................................ $51,866 $37,174 $103,048 $192,088
Real estate construction.................. 25,206 4,955 669 30,830
------- ------- -------- --------
Total................................... $77,072 $42,129 $103,717 $222,918
======= ======= ======== ========
Fixed rate loans.......................... $27,864 $ 29,760 $ 57,624
Variable or adjustable rate loans......... 14,264 73,957 88,221
------- -------- --------
Total................................... $42,128 $103,717 $145,845
======= ======== ========
Real Estate Lending
One- to Four-Family Residential Real Estate Lending. The majority of our
residential loans are secured by one- to four-family residences located in our
primary market area. Our underwriting standards require that one- to four-
family portfolio loans generally be owner-occupied and that loan amounts not
exceed 80% (90% with private mortgage insurance) of the current appraised
value or cost, whichever is lower, of the underlying collateral. Terms
typically range from 15 to 30 years. We offer both fixed-rate mortgages and
adjustable rate mortgages ("ARMs") with repricing based on a Treasury Bill or
other index. Our ability to generate volume in ARMs however, is largely a
function of consumer preference and the interest rate environment. Our current
5
policy is not to make ARMs with discounted initial interest rates (i.e.,
"teasers"). We generally sell all government guaranteed mortgages, both fixed
rate and adjustable rate. In addition, in connection with management's
strategies to control our interest rate sensitivity position, management
determines from time to time to what extent it will retain or sell other ARMs
and other fixed rate mortgages. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Asset/Liability Management".
Multifamily and Commercial Real Estate Lending. We have made, and anticipate
continuing to make, on a selective basis, multifamily and commercial real
estate loans in our primary market areas. Commercial real estate loans are
made for small shopping centers, warehouses and professional offices,
generally owner occupied. Cash flow coverage to debt servicing requirements is
generally 1.2 times or more. Our underwriting standards generally require that
the loan-to-value ratio for multifamily and commercial real estate loans not
exceed 80% of appraised value or cost, whichever is lower.
Multifamily and commercial real estate mortgage lending affords our banks an
opportunity to receive interest at rates higher than those generally available
from one- to four-family residential lending. However, loans secured by such
properties usually are greater in amount, more difficult to evaluate and
monitor and, therefore, involve a greater degree of risk than one- to four-
family residential mortgage loans. Because payments on loans secured by
multifamily and commercial real estate properties are often dependent on the
successful operation and management of the properties, repayment of these
loans may be affected by adverse conditions in the real estate market or the
economy. We seek to minimize these risks by strictly scrutinizing the
financial condition of the borrower, the quality of the collateral and the
management of the property securing the loan. We also generally obtain
personal guarantees from financially capable borrowers based on a review of
personal financial statements.
Construction Loans. We originate one- to four-family residential
construction loans for the construction of custom homes (where the home buyer
is the borrower) and provide financing to builders for the construction of
pre-sold homes and speculative residential construction (i.e. built before a
buyer is identified). We lend to builders who have demonstrated a favorable
record of performance and profitable operations and who are building in
markets that management understands and in which management is comfortable
with the economic conditions. We further endeavor to limit our construction
lending risk through adherence to strict underwriting procedures. Loans to one
builder are generally limited on a case-by-case basis with unsold home limits
based on builder strengths. Our underwriting standards require that the loan-
to-value ratio for pre-sold homes and speculative residential construction not
exceed 80% of appraised value or builder's cost less overhead, whichever is
less. Speculative construction and land development loans are generally short
term in nature and priced with a variable rate of interest using the prime
rate as the index. We generally require builders to have some tangible form of
equity in each construction project. Also, we generally require prompt and
thorough documentation of all draw requests and utilize outside inspectors to
inspect the project prior to paying any draw requests from builders.
Construction lending affords us the opportunity to achieve higher interest
rates and fees with shorter terms to maturity than does our single-family
permanent mortgage lending. Construction lending, however, is generally
considered to involve a higher degree of risk than single-family permanent
mortgage lending because of the inherent difficulty in estimating both a
property's value at completion of the project and the estimated costs of the
project. As a result, these loans are generally more difficult to evaluate and
monitor. If the estimate of construction cost proves to be inaccurate, we may
be required to advance funds beyond the amount originally committed to permit
completion of the project. If the estimate of value upon completion proves to
be inaccurate, we may be confronted with a project whose value is insufficient
to assure full repayment. Projects may also be jeopardized by disagreements
between borrowers and builders and by the failure of builders to pay
subcontractors. Loans to builders to construct homes for which no purchaser
has been identified carry more risk because the payoff for the loan depends on
the builder's ability to sell the property prior to the time the construction
loan is due.
6
Commercial Business Lending
We offer commercial loans to sole proprietorships, partnerships and
corporations with an emphasis on real estate related industries and firms in
agricultural, health care, legal and other professions. The types of commercial
loans offered are business lines of credit secured primarily by real estate,
accounts receivable and inventory, business term loans secured by real estate
for either working capital or lot acquisition, Small Business Administration
("SBA") loans and unsecured business loans.
Commercial business lending generally involves greater risk than residential
mortgage lending and risks that are different from those associated with
residential and commercial real estate lending. Real estate lending is
generally considered to be collateral based lending with loan amounts based on
predetermined loan to collateral values, and liquidation of the underlying real
estate collateral is viewed as the primary source of repayment in the event of
borrower default. Although our commercial business loans are often
collateralized by real estate, the decision to grant a commercial business loan
depends primarily on the credit worthiness and cash flow of the borrower (and
any guarantors), while liquidation of collateral is a secondary source of
repayment.
As of December 31, 1999, we had $192.1 million, or 46.0% of our total loans
receivable, in commercial business loans. Collateral for these loans is
generally owner occupied business or residential real estate. The average loan
size is approximately $200,000 with loans generally in amounts of $500,000 or
less.
Origination and Sales of Loans
We originate real estate and other loans with approximately two-thirds of the
residential mortgage volumes generated from our mortgage loan origination
office. Walk-in customers and referrals from real estate brokers are important
sources of loan originations.
Consistent with our asset/liability management strategy, we sell a majority
of our fixed rate and ARM residential mortgage loans into the secondary market.
At Heritage Bank, commitments to sell mortgage loans generally are made during
the period between the taking of the loan application and the closing of the
mortgage loan. The timing of making these sale commitments is dependent upon
the timing of the borrower's election to lock-in the mortgage interest rate and
fees prior to loan closing. Most of these sale commitments are made on a "best
efforts" basis whereby Heritage Bank is only obligated to sell the mortgage if
the mortgage loan is approved and closed by Heritage Bank. As a result,
management believes that market risk is minimal. At Central Valley Bank, all
mortgage loan production is brokered to other lenders prior to funding.
When we sell mortgage loans, we typically also sell the servicing of the
loans (i.e., collection of principal and interest payments). We serviced $18.8
million and $13.1 million in mortgage loans for others as of December 31, 1998
and December 31, 1999, respectively. We received fee income of $22,000 and
$34,000 for the six months ended December 31, 1998, and the year ended December
31, 1999 for these servicing activities on mortgage loans.
The following table presents summary information concerning our origination
and sale of residential mortgage loans and the gains achieved on such
activities.
Six month
Year ended June 30, ended Year ended
------------------- December 31 December 31
1997 1998 1998 1999
--------- --------- ----------- -----------
(Dollars in thousands)
One- to four-family
residential mortgage loans:
Originated.................. $ 104,145 $ 118,774 $68,434 $78,248
Sold........................ 87,003 101,903 57,490 58,266
Gains on sales of loans, net.. $ 2,006 $ 2,406 $ 1,297 $ 1,079
We have a minimal amount of purchased loans and loan participations.
7
Commitments and Contingent Liabilities
In the ordinary course of business, we enter into various types of
transactions that include commitments to extend credit that are not included
in our consolidated financial statements. We apply the same credit standards
to these commitments as we use in all our lending activities and have included
these commitments in our lending risk evaluations. Our exposure to credit loss
under commitments to extend credit is represented by the amount of these
commitments. At December 31, 1999, we had outstanding commitments to extend
credit, including letters of credit, in the amount of $87.9 million.
Delinquencies and Nonperforming Assets
Delinquency Procedures. When a borrower fails to make a required payment on
a loan, in the case of loans other than commercial loans, a late notice is
sent 15 days after the due date. If the delinquency is not cured by the 30th
day, a second notice is mailed and, if appropriate, the borrower is contacted
by telephone. Additional written and verbal contacts are made with the
borrower between 60 and 90 days after the due date.
In the event a real estate loan payment is past due for 45 days or more,
loan servicing personnel perform an in-depth review of the loan status, the
condition of the property, and the circumstances of the borrower. Based upon
the results of our review, we may negotiate and accept a repayment program
with the borrower, accept a voluntary deed in lieu of foreclosure or, when
deemed necessary, initiate foreclosure proceedings. If foreclosed on, real
property is sold at a public sale and we may bid on the property to protect
our interest. A decision as to whether and when to initiate foreclosure
proceedings is made by the loan committee and is based on such factors as the
amount of the outstanding loan in relation to the value of the property
securing the original indebtedness, the extent of the delinquency, and the
borrower's ability and willingness to cooperate in curing the delinquency.
Real estate acquired by us by deed in lieu of foreclosure is classified as
real estate owned until it is sold. When property is acquired, it is recorded
at the lower of cost or estimated fair value at the date of acquisition, not
to exceed net realizable value, and any write-down resulting therefrom is
charged to the allowance for loan losses. Upon acquisition, all costs incurred
in maintaining the property are expensed. Costs relating to the development
and improvement of the property, however, are capitalized to the extent of the
property's net realizable value.
We consider loans as in-substance foreclosed if the borrower has little or
no equity in the property based upon its estimated fair value, if repayment
can be expected only to come from operation or sale of the collateral, and if
the borrower has effectively abandoned control of the collateral or has
continued to retain control of the collateral but because of the borrower's
current financial status, it is doubtful that the borrower will be able to
repay the loan in the foreseeable future.
Delinquencies in the commercial business loan portfolio are handled on a
case-by-case basis. Generally, notices are sent and personal contact is made
with the borrower when the loan is 15 days past due. Loan officers are
responsible for collecting loans they originate or which are assigned to them.
Depending on the nature of the loan and the type of collateral securing the
loan, we may negotiate and accept a modified payment program or take other
actions as the circumstances warrant.
Classification of Assets. Federal regulations require that our banks
classify assets on a regular basis. In addition, in connection with
examinations of each bank, the Washington State Department of Financial
Institutions, Division of Banks, the Office of the Comptroller of the
Currency, and FDIC examiners have authority to identify problem assets and, if
appropriate, require them to be classified. There are three classifications
for problem assets: Substandard, Doubtful, and Loss. Substandard assets have
one or more defined weaknesses and are characterized by the distinct
possibility that the institution will sustain some loss if the deficiencies
are not corrected. Doubtful assets have the weaknesses of Substandard assets,
with the additional characteristics that the weaknesses make collection or
liquidation in full on the basis of currently existing facts, conditions and
values questionable, and there is a high possibility of loss. An asset
classified as Loss is
8
considered uncollectible and of such little value that continuance as an asset
of the institution is not warranted. Assets classified as Substandard or
Doubtful require the institution to establish prudent general allowances for
loan losses. If an asset or portion thereof is classified as Loss, the
institution must charge off such amount. The most recent examination of
Heritage Bank was completed by the FDIC in March 1999. Central Valley Bank was
examined by the Office of the Comptroller of the Currency in January 2000. The
regulators' assessments of our banks' classified assets were consistent with
our banks' internal classifications. An examination of Heritage Bank by the
Division was in progress during March 2000.
Nonperforming Assets. Nonperforming assets consist of nonaccrual loans and
restructured loans and real estate owned. The following table sets forth at
the dates indicated information with respect to nonaccrual loans, restructured
loans and real estate owned by us.
June 30, December 31,
---------------------------- ----------------
1996 1997 1998 1998 1999
-------- -------- -------- ------- -------
(Dollars in thousands)
Nonaccrual loans.............. $ 65 $ 146 $ 385 $ 401 $ 1,804
Restructured loans............ -- -- -- -- --
-------- -------- -------- ------- -------
Total nonperforming loans... 65 146 385 401 1,804
Real estate owned............. -- -- 82 -- --
-------- -------- -------- ------- -------
Total nonperforming assets.. $ 65 $ 146 $ 467 $ 401 $ 1,804
-------- -------- -------- ------- -------
Accruing loans past due 90
days or more................. $ -- $ -- $ 15 $ 8 $ --
Potential problem loans....... 1,836 239 1,758 877 2,826
Allowance for loan losses..... 2,221 3,105 3,929 3,957 4,264
Nonperforming loans to loans.. 0.03% 0.06% 0.12% 0.12% 0.43%
Allowance for loan losses to
loans........................ 1.12% 1.28% 1.25% 1.21% 1.02%
Allowance for loan losses to
nonperforming loans.......... 3398.23% 2133.01% 1019.90% 984.70% 236.27%
Nonperforming assets to total
assets....................... 0.02% 0.05% 0.10% 0.08% 0.35%
Nonaccrual Loans. Our financial statements are prepared on the accrual basis
of accounting, including the recognition of interest income on our loan
portfolio, unless a loan is placed on a nonaccrual basis. Loans are considered
to be impaired and are placed on nonaccrual status when there are serious
doubts about the collectibility of principal or interest. Our policy is to
place a loan on nonaccrual status when the loan becomes past due for 90 days
or more. Amounts received on nonaccrual loans generally are applied first to
principal and then to interest only after all principal has been collected.
Interest on nonaccrual loans foregone was $11,738, and $59,613 for the six
months ended December 31, 1998 and the year ended December 31, 1999,
respectively. Previous period interest foregone was immaterial.
Analysis of Allowance for Loan Losses
The allowance for loan losses is maintained at a level considered adequate
by management to provide for reasonably foreseeable loan losses based on
management's assessment of various factors affecting the loan portfolio,
including a review of problem loans, business conditions and loss experience
and an overall evaluation of the quality of the underlying collateral, holding
and disposal costs and costs of capital. The allowance is increased by
provisions for loan losses charged to operations and reduced by loans charged
off, net of recoveries.
Over the past three years, we have increased our allowance for loan losses
during a period of loan growth and change in loan portfolio composition. While
our loan portfolio, and in particular commercial loans, have grown
substantially over the past three years, our asset quality has remained very
solid as demonstrated by the low charge-offs and the low nonperforming assets
to total assets ratio during that period. In the year ended December 31, 1999,
we experienced net charge-offs of $101,000. Because commercial business
lending
9
generally involves greater risk than those associated with residential and
commercial real estate lending, we have increased the portion of our general
allowance for loan losses allocated to our commercial loans over the past
three years.
While we believe that we use the best information available to determine the
allowance for loan losses, if circumstances differ substantially from the
assumptions used in determining the allowance, or unforeseen market conditions
result in adjustments to the allowance for loan losses, net income could be
significantly affected.
The following table sets forth, for the periods indicated, information
regarding changes in our allowance for loan losses:
Six Months
Year Ended June 30, Ended Year Ended
---------------------------- December 31, December 31,
1996 1997 1998 1998 1999
-------- -------- -------- ------------ ------------
(Dollars in thousands)
Total loans outstanding
at end of period(1).... $198,908 $243,048 $314,095 $326,952 $417,762
Average loans
outstanding during
period................. $186,383 $213,560 $251,816 $319,645 $361,116
Allowance balance at
beginning of period.... $ 2,084 $ 2,221 $ 3,105 $ 3,929 $ 3,957
Provision for loan
losses................. -- (265) 149 202 408
Allowance acquired with
North Pacific Bank..... -- -- 670 -- --
Charge-offs:
Real estate(2)........ (20) -- -- (36) (120)
Commercial............ (2) (2) -- (146) (117)
Consumer.............. (1) (7) (3) (5) (10)
-------- -------- -------- -------- --------
Total charge-offs... (23) (9) (3) (187) (247)
-------- -------- -------- -------- --------
Recoveries:
Real estate(2)........ 156 1,155 4 4 113
Commercial............ 4 3 1 9 32
Consumer.............. -- -- 3 -- 1
-------- -------- -------- -------- --------
Total recoveries.... 160 1,158 8 13 146
-------- -------- -------- -------- --------
Net (charge-offs)
recoveries....... 137 1,149 5 (174) (101)
-------- -------- -------- -------- --------
Allowance balance at end
of period.............. $ 2,221 $ 3,105 $ 3,929 $ 3,957 $ 4,264
======== ======== ======== ======== ========
Ratio of net (charge-
offs) recoveries during
period to average loans
outstanding............ 0.07% 0.54% 0.00% 0.05% (0.03%)
======== ======== ======== ======== ========
- --------
(1) Includes loans held for sale
(2) During the periods shown, all of the charge-offs and recoveries shown
under the Real Estate category relate to real estate mortgages. None of
the above activity related to real estate construction loans.
10
The following table shows the allocation of the allowance for loan losses
for the indicated periods. The allocation is based upon an evaluation of
defined loan problems, historical ratios of loan losses for us and industry
wide and other factors which may affect future loan losses in the categories
shown below:
At June 30, At December 31,
----------------------------------------------- -------------------------------
1996 1997 1998 1998 1999
--------------- --------------- --------------- --------------- ---------------
% of % of % of % of % of
Total Total Total Total Total
Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1) Amount Loans(1)
------ -------- ------ -------- ------ -------- ------ -------- ------ --------
Balance applicable to:
Commercial.............. $ 593 15.4% $1,242 22.1% $2,217 37.4% $2,670 39.2% $3,070 45.8%
Real estate mortgages:
One- to four-family
residential........... 146 48.2 164 43.9 156 32.0 156 29.6 168 23.3
Five or more family
residential and
commercial
properties............ 1,112 27.9 900 27.2 678 22.9 669 21.3 721 22.5
Real estate
construction:
One- to four-family
residential........... 243 7.4 202 5.3 214 6.1 135 8.1 145 5.6
Five or more family
residential and
commercial
properties............ 12 0.2 31 0.4 10 0.2 16 0.6 17 1.8
Consumer................ 12 0.9 20 1.1 53 1.4 54 1.2 58 1.0
Unallocated............. 103 546 601 257 85
------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Total.................. $2,221 100.0% $3,105 100.0% $3,929 100.0% $3,957 100.0% $4,264 100.0%
====== ===== ====== ===== ====== ===== ====== ===== ====== =====
- --------
(1) Represents the total of all outstanding loans in each category as a
percent of total loans outstanding.
Investment Activities
At December 31, 1999, our investment securities portfolio totaled $42.5
million, consisting of $36.4 million of securities available for sale and $6.1
million of securities held to maturity. This compares with a total portfolio
of $47.6 million at December 31, 1998, comprised of $31.7 million of
securities available for sale and $15.9 million of securities held to
maturity. The composition of the two investment portfolios by type of
security, at each respective date, is presented in the tables below.
Our investment policies are established by the board of directors and
monitored by the Audit and Finance Committee. They are designed primarily to
provide and maintain liquidity, to generate a favorable return on investments
without incurring undue interest rate and credit risk, and to compliment our
bank's lending activities. These policies dictate the criteria for classifying
securities as either available for sale or held for investment. The policies
permit investment in various types of liquid assets permissible under
applicable regulations, which include U.S. Treasury obligations, U.S.
Government agency obligations, some certificates of deposit of insured banks,
mortgage backed and mortgage related securities, some corporate notes,
municipal bonds, FHLB stock and federal funds. Investment in non-investment
grade bonds is not permitted under the policies.
11
The following table summarizes the amortized cost, gross unrealized gains
and losses and the resulting fair value of securities available for sale:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- -------
(Dollars in thousands)
December 31, 1998
U.S. Government and its agencies...... $26,597 $ 72 $ (96) $26,573
Collateralized mortgage obligations... 2,812 (10) 2,802
Corporate notes and other............. 2,100 224 -- 2,324
------- ---- ----- -------
Totals.............................. $31,509 $296 $(106) $31,699
======= ==== ===== =======
December 31, 1999
U.S. Government and its agencies...... $33,192 $-- $(669) $32,523
Collateralized mortgage obligations... 1,611 (28) 1,583
Corporate notes and other............. 2,100 185 (13) 2,272
------- ---- ----- -------
Totals.............................. $36,903 $185 $(710) $36,378
======= ==== ===== =======
We had no securities available for trading at June 30, 1997, June 30, 1998,
December 31, 1998, or December 31, 1999.
The following table sets forth information regarding the carrying value,
weighted average yields and maturities or periods to repricing of our
investment securities available for sale at December 31, 1999.
At December 31, 1999
--------------------------
Weighted
Fair Average
BookValue Value Yield
--------- ------- --------
(Dollars in thousands)
Obligations of US Government agencies:
Due within one year................................ $ 2,000 $ 1,987 5.54%
Due after 1 year but within 5 years................ 31,192 30,536 5.61
------- -------
33,192 32,523
------- -------
Corporate notes and other investments
Due after 1 year but within 5 years................ 500 501 6.86
Due after 5 years but within 10 years.............. 500 495 6.29
Due after 10 years................................. 1,100 1,276 4.93
------- -------
2,100 2,272
------- -------
Collateralized mortgage obligations..................
Due after 5 years but within 10 years.............. 296 289 5.98
Due after 10 years................................. 1,315 1,294 6.55
------- -------
1,611 1,583
------- -------
Total all investments available for sale............. $36,903 $36,378
======= =======
12
The following table summarizes the amortized cost, gross unrealized gains
and losses and the resulting fair value of investment securities held to
maturity:
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------- ---------- ---------- -------
(Dollars in thousands)
December 31, 1998:
U.S. Government and its agencies...... $ 9,846 $ 26 $ (3) $ 9,869
Mortgage backed securities............ 3,262 86 -- 3,348
Municipal bonds....................... 2,789 77 (2) 2,864
------- ---- ---- -------
Total held for investment........... $15,897 $189 $ (5) $16,081
======= ==== ==== =======
December 31, 1999:
U.S. Government and its agencies...... $ 1,200 $-- $ (6) $ 1,194
Mortgage backed securities............ 2,399 95 (1) 2,493
Municipal bonds....................... 2,566 4 (38) 2,532
------- ---- ---- -------
Total held for investment........... $ 6,165 $ 99 $(45) $ 6,219
======= ==== ==== =======
The following table sets forth information regarding the carrying value,
weighted average yields and maturities or periods to repricing of our
investment securities held to maturity at December 31, 1999.
At December 31, 1999
----------------------
Weighted
Book Fair Average
Value Value Yield
------ ------ --------
(Dollars in thousands)
Obligations of US Government agencies:
Due within one year................................. $ 300 $ 300 6.10%
Due after 1 year but within 5 years................. 900 894 5.99
------ ------
1,200 1,194
------ ------
Municipal bonds
Due within one year................................. 456 459 7.03
Due after 1 year but within 5 years................. 1,412 1,398 6.80
Due after 5 years but within 10 years............... 700 676 6.11
------ ------
2,568 2,533
------ ------
Mortgage backed securities
Due within one year................................. 57 60 8.03
Due after 1 year but within 5 years................. 54 55 7.99
Due after 5 years but within 10 years............... 303 314 8.62
Due after 10 years.................................. 1,983 2,063 8.16
------ ------
2,397 2,492
------ ------
Total all investments held to maturity............ $6,165 $6,219
====== ======
- --------
(1) Tax equivalent weighted average yield.
We held $2.2 million of FHLB stock at December 31, 1999. The stock has no
contractual maturity and amounts in excess of the required minimum for FHLB
membership may be redeemed at par. At December 31, 1999, we were required to
maintain an investment in the stock of the FHLB of Seattle of at least $0.8
million.
13
Deposit Activities and Other Sources of Funds
General. Our primary sources of funds are deposits and loan repayments.
Scheduled loan repayments are a relatively stable source of funds, while
deposit inflows and outflows and unscheduled loan prepayments, which are
influenced significantly by general interest rate levels, interest rates
available on other investments, competition, economic condition and other
factors, are not. Our deposit balances increased by $38.1 million in 1999
including an increase of $49.3 million in Public fund deposits. Customer
deposits remain an important source, but these balances have been influenced
in the past by adverse market changes in the industry and may be affected by
similar developments in the future. Borrowings may be used on a short term
basis to compensate for reductions in other sources of funds (such as deposit
inflows at less than projected levels). Borrowings may also be used on a
longer term basis to support expanded lending activities and to match the
maturity of repricing intervals of assets.
Deposit Activities. We offer a variety of accounts for depositors designed
to attract both short-term and long-term deposits. These accounts include
certificates of deposit ("CDs"), regular savings accounts, money market
accounts, checking and negotiable order of withdrawal ("NOW") accounts, and
individual retirement accounts ("IRAs"). These accounts generally earn
interest at rates established by management based on competitive market
factors and management's desire to increase or decrease certain types or
maturities of deposits. At December 31, 1999, we had no brokered deposits. The
more significant deposit accounts offered by us are described below.
Certificates of Deposit. We offer several types of CDs with maturities
ranging from 30 days to five years and which require a minimum deposit of
$100. In addition, we offer a CD that has a maturity of four to 11 months and
a minimum deposit of $2,500, and permits additional deposits at the initial
rate throughout the certificate term. Interest is credited quarterly or at
maturity. Finally, negotiable CDs are offered in amounts of $100,000 or more
for terms of 30 days to 12 months. The negotiable CDs pay simple interest
credited at maturity.
Regular Savings Accounts. We offer savings accounts that allow for unlimited
deposits and withdrawals, provided that a $100 minimum balance is maintained.
Interest is compounded daily and credited quarterly.
Money Market Accounts. Money market accounts pay a variable interest rate
that is tiered depending on the balance maintained in the account. Minimum
opening balances vary. Interest is compounded daily and paid monthly.
Checking and NOW Accounts. Checking and NOW accounts are non-interest and
interest bearing and may be charged service fees based on activity and
balances. NOW accounts pay interest, but require a higher minimum balance to
avoid service charges.
Individual Retirement Accounts. IRAs permit annual contributions regulated
by law and pay interest at fixed rates. Maturities are available from one to
five years and interest is compounded daily and credited quarterly.
14
Sources of Funds
Deposit Activities. The following table sets forth for the periods indicated
the average balances outstanding and the weighted average interest rates for
each major category of deposits:
Year Ended June 30, Six Months Ended Year Ended
--------------------------------- December 31, December 31,
1997 1998 1998 1999
---------------- ---------------- ---------------- ----------------
Average Average Average Average Average Average Average Average
Balance Rate Balance Rate Balance Rate Balance Rate
(1) Paid (1) Paid (1) Paid (1) Paid
-------- ------- -------- ------- -------- ------- -------- -------
(Dollars in thousands)
Interest bearing demand
and money market
accounts............... $ 53,850 3.16% $ 62,577 3.12% $ 82,746 2.82% $ 91,281 2.69%
Savings................. 35,269 3.45 41,863 3.50 63,986 3.48 68,484 3.33
Certificates of
deposit................ 134,226 5.54 150,970 5.56 177,956 5.46 165,490 5.00
Total interest bearing
deposits.............. 223,345 4.64 255,410 4.62 324,688 4.40 325,255 4.00
Demand and other
noninterest bearing
deposits............... 16,412 -- 22,759 -- 36,540 -- 37,906 --
-------- ---- -------- ---- -------- ---- -------- ----
Total deposits......... $239,757 4.32% $278,169 4.25% $361,228 3.95% $363,161 3.58%
======== ==== ======== ==== ======== ==== ======== ====
- --------
(1) Average balances were calculated using average daily balances.
The following table sets forth for the periods indicated the change in the
balances of deposits during the year and the impact of interest credited
thereon.
Year Ended June Six months
30, Ended Year Ended
------------------ December 31, December 31,
1997 1998 1998 1999
-------- -------- ------------ ------------
(Dollars in thousands)
Net increase (decrease) in
deposits.................... $ 27,072 $109,505 $ 3,469 $ 38,070
Less: Interest credited.... (10,114) (11,494) (6,482) (12,631)
-------- -------- ------- --------
Net increase(decrease) before
interest credited........... $ 16,958 $ 98,011 $(3,013) $ 25,439
======== ======== ======= ========
Of the $98.0 million net increase in deposits for the year ended June 30,
1998, $82.4 million resulted from the acquisition of North Pacific Bank, which
was effective June 12, 1998.
The following table shows the amount and maturity of certificates of
deposits of $100,000 or more as of December 31, 1999:
December 31,
1999
------------
(Dollars in
thousands)
Remaining maturity:
Three months or less...................................... $52,017
Over three months through six months...................... 8,951
Over six months through 12 months......................... 12,211
Over twelve months........................................ 3,779
-------
Total................................................... $76,958
=======
At December 31, 1998 and December 31, 1999 certificates of deposits with
balances of $100,000 or more totaled $30.8 million and $77.0 million,
respectively.
15
Borrowings. Savings deposits are the primary source of funds for our lending
and investment activities and for our general business purposes. We rely upon
advances from the FHLB of Seattle to supplement our supply of lendable funds
and to meet deposit withdrawal requirements. The FHLB of Seattle has served as
one of our secondary sources of liquidity. Advances from the FHLB of Seattle
are typically secured by our first mortgage loans, and stock issued by the
FHLB of Seattle, which is held by us.
The FHLB functions as a central reserve bank providing credit for member
financial institutions. As a member, Heritage Bank is required to own capital
stock in the FHLB and is authorized to apply for advances on the security of
such stock and certain of its mortgage loans and other assets (principally
securities which are obligations of, or guaranteed by, the United States)
provided certain standards related to creditworthiness have been met. It is
anticipated that Central Valley Bank will become a member early in 2000.
Advances are made pursuant to several different programs. Each credit program
has its own interest rate and range of maturities. Depending on the program,
limitations on the amount of advances are based either on a fixed percentage
of an institution's net worth or on the FHLB's assessment of the institution's
creditworthiness. Under its current credit policies, the FHLB of Seattle
generally limits advances to 20.0% of a member's assets, and overnight
borrowings may not exceed 5.0% of the institution's assets. The FHLB of
Seattle determines specific lines of credit for each member institution.
The following table is a summary of FHLB advances for the years ended June
30, 1997, June 30, 1998, the six months ended December 31, 1998, and the year
ended December 31, 1999:
At or for
the year At or for At or for
ended the six the year
June 30, months ended ended
------------ December 31, December 31,
1997 1998 1998 1999
----- ------ ------------ ------------
(Dollars in thousands)
Balance at period end.............. $ -- $ 890 $ 687 $2,800
Average balance during the period.. -- 27 693 958
Maximum amount outstanding at any
month end......................... -- 1,300 696 3,300
Average interest rate:
During the period................ -- 5.47% 6.20% 5.90%
At period end.................... -- 6.45% 6.20% 5.70%
16
The following table is a summary of other borrowed funds for the years ended
June 30, 1997 and June 30, 1998, the six months ended December 31, 1998 and
the year ended December 31, 1999.
At or for
the year At or for At or for
ended the six the year
June 30, months ended ended
------------ December 31, December 31,
1997 1998 1998 1999
----- ----- ------------ ------------
(Dollars in thousands)
Securities sold under agreements to
repurchase:
Balance at period end................ $ -- $ 610 $ -- $ --
Average balance during the period.... -- 21 320 --
Maximum amount outstanding at any
month end........................... -- 610 483 --
Average interest rate:
During the period.................. -- 3.25% 3.25% --
At period end...................... -- 3.25% -- --
Subordinated debentures:
Balance at period end................ $ -- $ 500 $ -- $ --
Average balance during the period.... -- 25 500 --
Maximum amount outstanding at any
month end........................... -- 500 500 --
Average interest rate:
During the period.................. -- 7.64% 7.64% --
At period end...................... -- 7.64% -- --
Notes Payable:
Balance at period end................ $ 525 $ 320 $ 17 $ 8
Average balance during the period.... 600 451 93 12
Maximum amount outstanding at any
month end........................... 675 547 319 16
Average interest rate:
During the period.................. 9.25% 9.23% 7.29% 0.00%
At period end...................... 9.25% 8.61% 0.00% 0.00%
Notes Payable at December 31, 1998 and December 31, 1999 include a non
interest bearing note to Tacoma City Light for energy conservation improvement
that was acquired in June 1998 with North Pacific Bank.
Supervision and Regulation
We and our banks are subject to extensive federal and Washington state
legislation, regulation and supervision. These laws and regulations are
primarily intended to protect depositors and the FDIC rather than
stockholders. The laws and regulations affecting banks and bank holding
companies have changed significantly over recent years, and it is reasonable
to expect that similar changes will continue in the future. Any change in
applicable laws, regulations or regulatory policies may have a material effect
on our business, operations and prospects. We cannot predict the nature or the
extent of the effects on our business and earnings that any fiscal or monetary
policies or new federal or state legislation may have in the future.
The following information is qualified in its entirety by reference to the
particular statutory and regulatory provisions described.
Heritage Financial. We are subject to regulation as a bank holding company
within the meaning of the Bank Holding Company Act of 1956, as amended, and
are supervised by the Federal Reserve. The Federal Reserve has the authority
to order bank holding companies to cease and desist from unsound practices and
violations of conditions imposed on it. The Federal Reserve is also empowered
to assess civil money penalties against companies and individuals who violate
the Bank Holding Company Act or orders or regulations thereunder in amounts up
to $1.0 million per day or order termination of non-banking activities of non-
banking subsidiaries of bank holding companies, and to order termination of
ownership and control of a non-banking
17
subsidiary by a bank holding company. Some violations may also result in
criminal penalties. The FDIC and OCC are authorized to exercise comparable
authority under the Federal Deposit Insurance Act, the National Bank Act and
other statutes with respect to state nonmember banks such as Heritage Bank or
national banks such as Central Valley Bank.
The Federal Reserve takes the position that a bank holding company is
required to serve as a source of financial and managerial strength to its
subsidiary banks and may not conduct its operations in an unsafe or unsound
manner. In addition, it is the Federal Reserve's position that in serving as a
source of strength to its subsidiary banks, bank holding companies should be
prepared to use available resources to provide adequate capital funds to its
subsidiary banks during periods of financial stress or adversity and should
maintain the financial flexibility and capital raising capacity to obtain
additional resources for assisting its subsidiary banks. A bank holding
company's failure to meet its obligations to serve as a source of strength to
its subsidiary banks will generally be considered by the Federal Reserve to be
an unsafe and unsound banking practice or a violation of the Federal Reserve's
regulations or both. The Federal Deposit Insurance Act requires an
undercapitalized institution to submit to the Federal Reserve a capital
restoration plan with a guaranty by each company having control of the bank's
compliance with the plan.
We are required to file an annual report and periodic reports with the
Federal Reserve and additional information as the Federal Reserve may require.
The Federal Reserve may examine us and any of our subsidiaries and charge us
for the cost of the examination.
We and any subsidiaries which we may control are deemed "affiliates" within
the meaning of the Federal Reserve Act, and transactions between our bank
subsidiaries and our affiliates are subject to numerous restrictions. With
some exceptions, we and our subsidiaries are prohibited from tying the
provision of various services, such as extensions of credit, to other services
offered by us or our affiliates.
Bank 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%. 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 stockholders'
equity (which does not include unrealized gains and losses on securities),
less goodwill and certain identifiable intangible assets, while Tier II
capital includes the allowance for loan losses and subordinated debt, both
subject to some limitations. Regulatory risk-based capital guidelines require
Tier I capital of 4% of risk-adjusted assets and minimum total capital ratio
(combined Tier I and Tier II) of 8%.
Subsidiaries. Heritage Bank is a Washington state-chartered savings bank,
the deposits of which are insured by the FDIC. Heritage Bank is subject to
regulation by the FDIC and the Washington State Department of Financial
Institutions Division of Banks. Central Valley Bank is a nationally chartered
bank insured by the FDIC, and subject to the Office of the Comptroller of the
Currency, and is a member of the Federal Reserve System. Although Heritage
Bank is not a member of the Federal Reserve System, the Federal Reserve
supervisory authority over us may also affect Heritage Bank.
Among other things, applicable federal and state statutes and regulations
which govern a bank's operations relate to minimum capital requirements,
required reserves against deposits, investments, loans, legal lending limits,
mergers and consolidation, borrowings, issuance of securities, payment of
dividends, establishment of branches and other aspects of its operations. The
Division, the OCC and the FDIC also have authority to prohibit banks under
their supervision from engaging in what they consider to be unsafe and unsound
practices.
The banks are required to file periodic reports with the FDIC, the Division,
or the OCC, and are subject to periodic examinations and evaluations by those
regulatory authorities. Based upon these evaluations, the regulators may
revalue the assets of an institution and require that it establish specific
reserves to compensate for the differences between the regulator-determined
value and the book value of such assets. These examinations must be conducted
every 12 months, except that well-capitalized banks may be examined every 18
months. The
18
FDIC and the Division may each accept the results of an examination by the
other in lieu of conducting an independent examination.
As subsidiaries of a bank holding company, our banks are subject to various
restrictions in their dealings with us and with other companies that may
become affiliated with us.
In addition to earnings on the portion of net stock offering proceeds
retained by us, dividends paid by our subsidiaries will provide substantially
all of our cash flow. Applicable federal and Washington state regulations
restrict capital distributions by our banks, including dividends. Such
restrictions are tied to the institution's capital levels after giving effect
to such distributions. The FDIC and OCC have established the qualifications
necessary to be classified as a "well-capitalized" bank, primarily for
assignment of FDIC risk-based insurance premium rates beginning in 1993. To
qualify as "well-capitalized", banks must have a Tier I risk-adjusted capital
ratio of at least 6%, a total risk-adjusted capital ratio of at least 10%, and
a leverage ratio of at least 5%. Both Heritage Bank and Central Valley Bank
were qualified as "well-capitalized" at December 31, 1999.
Federal laws generally bar institutions which are not well capitalized from
accepting brokered deposits. The FDIC has issued rules which prohibit under-
capitalized institutions from soliciting or accepting brokered deposits.
Adequately capitalized institutions are allowed to solicit brokered deposits,
but only to accept them if a waiver is obtained from the FDIC.
Other Regulatory Developments. Congress has enacted significant federal
banking legislation in recent years. Included in this legislation have been:
The FIRREA and the Federal Deposit Insurance Corporation Improvement Act of
1991 ("FDICIA").
FIRREA, among other things,
. created two deposit insurance funds administered by the FDIC, the Bank
Insurance Fund ("BIF") and the SAIF;
. permitted commercial banks that meet certain housing-related asset
requirements to secure advances and other financial services from local
FHLBs;
. restructured the federal regulatory agencies for savings associations;
and
. greatly enhanced the regulators enforcement powers over financial
institutions and their affiliates.
FDICIA went substantially farther than FIRREA in establishing a more
rigorous regulatory environment. Under FDICIA, regulatory authorities are
required to enact a number of new regulations, substantially all of which are
now effective. These regulations include, among other things,
. a new method for calculating deposit insurance premiums based on risk,
. restrictions on acceptance of brokered deposits except by well-
capitalized institutions,
. additional limitations on loans to executive officers and directors of
banks,
. the employment of interest rate risk in the calculation of risk-based
capital,
. safety and soundness standards that take into consideration, among other
things, management, operations, asset quality, earnings and
compensation,
. a five-tiered rating system from well-capitalized to critically
undercapitalized, along with the prompt corrective action the agencies
may take depending on the category, and
. new disclosure and advertising requirements with respect to interest
paid on savings accounts.
FDICIA and regulations adopted by the FDIC impose additional requirements
for annual independent audits and reporting when a bank begins a fiscal year
with assets of $500 million or more. These banks, or their holding
19
companies, are also required to establish audit committees consisting of
directors who are independent of management.
The Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994. This act provides banks with greater opportunities to merge with other
institutions and to open branches nationwide and also allows a bank holding
company whose principal operations are in one state to apply to the Federal
Reserve for approval to acquire a bank that is headquartered in a different
state. States cannot "opt out" but may impose minimum time periods, not to
exceed five years, for the target bank's existence. This act also allows bank
subsidiaries of bank holding companies to establish "agency" relationships
with their depository institution affiliates. In an agency relationship, a
bank can accept deposits, renew time deposits, close and service loans, and
receive payments for a depository institution affiliate. States cannot "opt
out". This act allows banks whose principal operations are located in
different states to apply to federal regulators to merge. This provision took
effect June 1, 1997, unless states enacted laws to either authorize such
transactions at an earlier date or prohibit such transactions entirely. The
Interstate Banking Act also allows banks to apply to establish de novo
branches in states in which they do not already have a branch office. This
provision took effect June 1, 1997, but (i) states must enact laws to permit
such branching and (ii) a bank's primary federal regulator must approve any
such branch establishment. The Washington legislature passed legislation that
allows, subject to certain conditions, mergers or other combinations,
relocations of banks' main office and branching across state lines in advance
of the June 1, 1997 date established by federal law.
Recent Legislation
Financial Services Reform Legislation. On November 12, 1999, the Gramm-
Leach-Bliley Act ("GLBA") was enacted into law. The GLBA removes various
barriers imposed by the Glass-Steagall Act of 1933, specifically those
prohibiting banks and bank holding companies from engaging in the securities
and insurance business. The GLBA also expands the bank holding company act
framework to permit bank holding companies with subsidiary banks meeting
certain capital and management requirements to elect to become a "financial
holding company".
Beginning March, 2000, financial holding companies may engage in a full
range of financial activities, including not only banking, insurance and
securities activities, but also merchant banking and additional activities
determined to be "financial in nature" or "complementary" to an activity that
is financial in nature. The GLBA also provides that the list of permissible
financial activities will be expanded as necessary for a financial holding
company to keep abreast of competitive and technological changes.
The GLBA also expands the activities in which insured state banks may
engage. Under the GLBA, insured state banks are given the ability to engage in
financial activities through a subsidiary, as long as the bank and its bank
affiliates meet and comply with certain requirements. First, the state bank
and each of its bank affiliates must be "well capitalized". Second, the bank
must comply with certain capital deduction and financial statement
requirements provided under the GLBA. Third, the bank must comply with certain
financial and operational safeguards provided under the GLBA. Fourth, the bank
must comply with the limits imposed by the GLBA on transactions with
affiliates.
Although the GLBA preserves the Federal Reserve as the umbrella supervisor
of financial holding companies, it adopts an administrative approach to
regulation that defers to the action and paperwork requirements of the
"functional" regulators of insurers, broker-dealers, investment companies and
banks. Thus, the various state and federal regulators of a financial holding
company's operating subsidiaries would retain their jurisdiction and authority
over those operating entities. As the umbrella supervisor, however, the
Federal Reserve has the potential to affect the operations and activities of a
financial holding company's subsidiaries through its power over the financial
holding company parent. In addition, the GLBA contains numerous trigger points
related to legal non-compliance and other serious problems affecting bank
affiliates that could lead to direct Federal Reserve involvement and to the
possible exercise of remedial authority affecting both financial holding
companies and their affiliated operating companies.
20
Deposit Insurance Matters. Heritage Bank's deposit accounts are insured by
the FDIC under the SAIF to the maximum extent permitted by law. Central Valley
Bank is insured by the FDIC under the BIF to the maximum extent permitted by
law. Each bank pays deposit insurance premiums to the FDIC based on a risk-
based assessment system established by the FDIC for all member institutions.
Under applicable regulations, institutions are assigned to one of three
capital groups that are based solely on the level of an institution's capital
("well capitalized", "adequately capitalized" or " undercapitalized"), which
are defined in the same manner as the regulations establishing the prompt
corrective action system under the FDIC as described above. The matrix so
created results in nine assessment risk classifications.
Pursuant to recent changes in federal law, the FDIC imposed a special
assessment on each depository institution with SAIF-assessable deposits which
resulted in the SAIF achieving its designated reserve ratio. In connection
with that, the FDIC reduced the assessment schedule for SAIF members,
effective January 1, 1997, to a range of 0% to 0.27%, with most institutions,
including Heritage Bank, paying 0%. This assessment schedule is the same as
that for the BIF, which reached its designated reserve ratio in 1995. In
addition, since January 1, 1997, SAIF members are charged an assessment of
approximately 0.06% of SAIF-assessable deposits for the purpose of paying
interest on the bonds issued by the Financing Corporation in the 1980s to help
fund the thrift industry cleanup. BIF-assessable deposits will be charged an
assessment to help pay interest on the bonds at a rate of approximately .013%
until the earlier of December 31, 1999 or the date upon which the last savings
association ceases to exist, after which time the assessment will be the same
for all insured deposits. Recent legislative changes provided for the merger
of the BIF and SAIF into the Deposit Insurance Fund on January 1, 1999, but
only if no insured depository institutions were savings associations on that
date. This merger did not occur.
Competition
We compete for loans and deposits with other thrifts, commercial banks,
credit unions, mortgage bankers and other institutions in the scope and type
of services offered, interest rates paid on deposits, pricing of loans, and
number and locations of branches, among other things. Many of our competitors
have substantially greater resources than we do. Particularly in times of high
or rising interest rates, we also face significant competition for investors'
funds from short term money market securities and other corporate and
government securities.
We compete for loans principally through the range and quality of the
services we provide, interest rates and loan fees, and the locations of our
banks' branches. We actively solicit deposit-related clients and compete for
deposits by offering depositors a variety of savings accounts, checking
accounts and other services.
Employees
At December 31, 1999, we had 222 full-time equivalent employees. We believe
that employees play a vital role in the success of a service company. None of
our employees are covered by a collective bargaining agreement with us and we
believe that we have a good relationship with our employees.
ITEM 2. PROPERTIES
Our executive offices and the main office of Heritage Bank are located in
approximately 22,000 square feet of the headquarters building and adjacent
office space which are owned and located in downtown Olympia. At December 31,
1999, Heritage Bank had six offices located in Tacoma and surrounding areas of
Pierce County, (all but one of which are owned) five offices located in
Thurston County (all of which are owned with one office located on leased
land) and one office in Shelton, Mason County (which is owned). Central Valley
Bank had five offices located in Yakima County (all of which are owned).
21
ITEM 3. LEGAL PROCEEDINGS
We and our banks have certain litigation and negotiations in progress
resulting from activities arising from normal operations. In our opinion, none
of these matters is likely to have a material adverse effect on our financial
position or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
22
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Our common stock is traded on the NASDAQ National Market(R) under the symbol
HFWA. At December 31, 1999, we had approximately 1,492 stockholders of record
(not including the number of persons or entities holding stock in nominee or
street name through various brokerage firms) and 10,076,216 outstanding shares
of common stock. The last reported sales price on March 8, 2000 was $7.75 per
share. The following table sets forth for the quarters indicated the range of
high and low bid information per share of our common stock as reported on the
NASDAQ National Market(R).
1999 Quarter ended:
-----------------------------------------
March 31 June 30 September 30 December 31
-------- ------- ------------ -----------
High............................. $10.00 $8.69 $8.50 $8.75
Low.............................. $ 8.13 $7.73 $7.68 $7.37
Since our stock offering in January 1998, we have declared the following
quarterly cash dividends:
Cash
Dividend
Declared per share Record Date Paid
-------- --------- ---------------- ----------------
March 24, 1998................. $0.035 April 6, 1998 April 15, 1998
June 23, 1998.................. $0.040 July 6, 1998 July 15, 1998
September 18, 1998............. $0.045 October 6, 1998 October 15, 1998
December 17, 1998.............. $0.050 January 15, 1999 January 25, 1999
March 25, 1999................. $0.055 April 15, 1999 April 26, 1999
June 18, 1999.................. $0.060 July 15, 1999 July 27, 1999
September 17, 1999............. $0.065 October 15, 1999 October 27, 1999
December 16, 1999.............. $0.070 January 14, 1999 January 27, 1999
Dividends from us depend, in part, upon earnings from the investment of the
net proceeds from the Conversion retained by us and receipt of dividends from
our subsidiary banks. The FDIC and the Division have the authority under their
supervisory powers to prohibit the payment of dividends by Heritage Bank to
us. For a period of ten years after the Conversion, Heritage Bank may not,
without prior approval of the Division, declare or pay a cash dividend in an
amount in excess of one-half of the greater of the Bank's net income for the
current fiscal year or the average of the Bank's net income for the current
fiscal year and not more than two of the immediately preceding fiscal years.
In addition, Heritage Bank may not declare or pay a cash dividend on its
common stock if the effect of the dividend would be to reduce the Bank's net
worth below the amount required for the liquidation account. For Central
Valley Bank the approval of the Comptroller of the Currency is required if the
total of all dividends declared by Central Valley Bank in any calendar year
exceeds the total of its net income of that year combined with its retained
net income of the preceding two years, less any required transfer of surplus
or fund for the retirement of any preferred stock. Other than the specific
restrictions mentioned above, current regulations allow us and our subsidiary
banks to pay dividends on their common stock if our or our bank's regulatory
capital would not be reduced below the statutory capital requirements set by
the Federal Reserve, the OCC and the FDIC.
23
ITEM 6. SELECTED FINANCIAL DATA
For the six For the
For the year ended June 30, months ended year ended
---------------------------------- December 31, December 31,
1995 1996 1997 1998 1998 1999
------- ------- ------- ------- ------------ ------------
(Dollars in thousands, except per share data)
Operations Data:
Net interest income..... $10,138 $10,504 $12,043 $16,110 $11,017 $23,458
Provision for loan
losses................. -- -- (265) 149 202 408
Noninterest income...... 3,389 4,794 3,748 4,261 2,901 4,038
Noninterest expense..... 9,294 10,505 13,445 13,690 10,275 18,773
Provision (benefit) for
income taxes........... 1,345 1,617 12 2,273 1,275 2,958
Net income.............. 2,888 3,176 2,598 4,259 2,166 5,357
Earnings per share
Basic................. 0.28 0.31 0.25 0.41 0.20 0.50
Diluted............... 0.28 0.31 0.24 0.40 0.20 0.49
Dividend payout ratio
(1).................... NM NM NM 18.4% 47.3% 50.1%
Performance Ratios:
Net interest spread..... 3.45% 4.14% 4.30% 4.14% 4.13% 4.55%
Net interest margin
(2).................... 4.89% 4.63% 4.80% 5.05% 5.16% 5.49%
Efficiency ratio (3).... 68.71% 68.67% 85.15% 67.20% 73.83% 68.27%
Return on average
assets................. 1.28% 1.27% 0.94% 1.23% 0.92% 1.14%
Return on average
equity................. 11.81% 11.30% 8.74% 6.77% 4.36% 5.32%
At June 30, At December 31,
-------------------------------------- ------------------
1995 1996 1997 1998 1998 1999
-------- -------- -------- -------- -------- --------
Balance Sheet Data:
Total assets............ $239,827 $262,428 $291,323 $471,030 $475,871 $510,958
Loans receivable, net... 174,095 191,400 233,621 303,754 315,376 412,909
Loans held for sale..... 5,944 5,287 6,322 6,412 7,618 589
Deposits................ 205,517 226,951 254,024 363,529 366,998 405,068
Federal Home Loan Bank
advances............... -- -- 890 698 687 2,800
Other borrowings........ 3,252 -- 525 1,633 17 8
Stockholders' equity.... 26,488 29,161 31,588 98,593 100,559 95,264
Book value per share.... NM NM NM $ 9.20 $ 9.27 $ 9.50
Equity to assets ratio.. 11.04% 11.11% 10.84% 20.93% 21.13% 18.68%
Asset Quality Ratios:
Nonperforming loans to
loans.................. 0.12% 0.03% 0.06% 0.06% 0.12% 0.43%
Allowance for loan
losses to loans........ 1.14% 1.12% 1.28% 1.25% 1.21% 1.02%
Allowance for loan
losses to nonperforming
loans.................. 973.83% 3398.23% 2133.01% 1019.90% 984.70% 236.27%
Nonperforming assets to
total assets........... 0.09% 0.02% 0.05% 0.10% 0.08% 0.35%
Other Data:
Number of banking
offices................ 8 10 12 14 16 17
Number of full-time
equivalent employees... 144 145 170 180 229 222
- --------
(1) Dividend payout ratio is declared dividends per share divided by earnings
per share. Cash dividends prior to the January 1998 stock offering and
conversion are not comparable to prior periods due to the former mutual
holding company's waiver of its pro rata cash dividends.
(2) Net interest margin is net interest income divided by average interest
earning assets.
(3) The efficiency ratio is recurring noninterest expense divided by the sum
of net interest income and noninterest income, excluding nonrecurring
items. Heritage Bank paid a one-time assessment of $1.09 million to the
Savings Association Insurance Fund in November 1996 (fiscal year 1997).
This amount was excluded from the calculation of the efficiency ratio for
1997.
24
ITEM 7. 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 operations of the Company. The information
contained in this section should be read in conjunction with the December 31,
1999 audited consolidated financial statements and notes to those financial
statements included in this Form 10-K.
Statements concerning future performance, developments or events, concerning
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.
General
In the fiscal year ended June 30, 1994, we began to implement a growth
strategy to broaden our products and services from traditional thrift
offerings to those more closely related to commercial banking. That strategy
entails:
. geographic and product expansion
. loan portfolio diversification
. development of relationship banking
. maintenance of asset quality
We incurred substantial expenses as we have carried out our growth strategy.
Those expenses have been concentrated in
. personnel hired in anticipation of growth and expanded market share
. maintaining the mortgage origination capacity during times of
fluctuating mortgage origination volumes
. facilities expansion
. upgrading data processing capabilities
These expenditures had a negative impact on our earnings in the fiscal year
ended June 30, 1997, the fiscal year ended June 30, 1998 and for the six
months ended December 31, 1998. Positive results from those expenditures
emerged in the second half of 1999 as the efficiency ratio improved from
73.83% for 1998 to 68.27% for 1999.
In the fiscal year ended June 30, 1998, our growth strategy was further
bolstered by two significant events:
. the January 1998 stock offering and conversion
. our acquisition of North Pacific Bancorporation.
Through the January 1998 stock offering, we raised $63.0 million in net new
capital which has, and will continue to, enhance our ability to implement our
growth strategy. Using $17.5 million of the net proceeds of the stock
offering, we completed out first bank acquisition in June 1998 by purchasing
all of the outstanding stock of North Pacific Bancorporation whose wholly
owned subsidiary was North Pacific Bank. The acquisition of North Pacific Bank
provided further geographical expansion into the Pierce County market area and
enhanced
25
expertise in commercial banking. While this acquisition had a significant
impact on our growth and financial condition at June 30, 1998, North Pacific
Bank's operations had a minimal impact on our earnings for the year ended June
30, 1998 due to the timing of the closing of the transaction on June 12, 1998.
During the six months ended December 31, 1998, we integrated the operations of
North Pacific Bank into Heritage Bank culminating in the merging of data
processing systems effective November 20, 1998 and substantially upgrading
North Pacific Bank's item processing capability to handle existing and
projected future volumes. We invested $1.1 million in item processing hardware
and software and facilities which became operational in December 1998.
Consistent with our strategy, on March 5, 1999 we merged with Washington
Independent Bancshares, Inc., whose wholly owned subsidiary was Central Valley
Bank. In the merger, we exchanged 1,058,009 shares of our common stock for all
of the outstanding shares of Washington Independent common stock. This merger
was accounted for as a pooling of interests and accordingly, our financial
information reported herein has been restated to include the accounts and
results of operations of Washington Independent for all periods presented.
Net Interest Income
Our profitability depends primarily on our net interest income, which is the
difference between the income we receive on our loan and investment portfolios
and our cost of funds, which consists of interest paid on deposits and
borrowed funds. Like most financial institutions, our interest income and cost
of funds are affected significantly by general economic conditions,
particularly changes in market interest rates and by government policies.
Changes in net interest income result from changes in volume, net interest
spread and net interest margin. Volume refers to the average dollar amounts of
interest earning assets and interest bearing liabilities. Net interest spread
refers to the difference between the average yield on interest earning assets
and the average cost of interest bearing liabilities. Net interest margin
refers to net interest income divided by average interest earning assets and
is influenced by the level and relative mix of interest earning assets and
interest bearing liabilities.
26
The following tables set forth, for the periods indicated statistics for us
related to net interest income. 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.
Year Ended December 31,
----------------------------------------------------
1998 1999
------------------------- -------------------------
Average Interest Average Interest
Balance Earned/ Average Balance Earned/ Average
(1) Paid Rate (1) Paid Rate
-------- -------- ------- -------- -------- -------
(Dollars in thousands)
Interest Earning Assets:
Loans..................... $289,745 $27,703 9.56% $361,116 $32,886 9.11%
Mortgage Backed
Securities............... 3,934 340 8.64 2,773 227 8.19
Investment securities and
FHLB stock............... 37,768 1,999 5.29 44,270 2,591 5.85
Interest earning
deposits................. 60,374 3,330 5.52 18,745 820 4.37
-------- ------- ------ -------- ------- ------
Total interest earning
assets................... 391,821 $33,372 8.52% 426,904 $36,524 8.56%
Noninterest earning
assets................... 35,274 44,637
-------- ------- ------ -------- ------- ------
Total assets............. $427,095 $471,541
======== ======= ====== ======== ======= ======
Interest Bearing
Liabilities:
Certificates of deposit... $166,818 $ 9,168 5.50% $165,490 $ 8,271 5.00%
Savings accounts.......... 53,264 1,836 3.45 68,484 2,279 3.33
Interest bearing demand
and money market
accounts................. 73,512 2,145 2.92 91,281 2,458 2.69
-------- ------- ------ -------- ------- ------
Total interest bearing
deposits................. 293,594 13,149 4.48 325,255 13,008 4.00
FHLB advances............. 381 22 5.67 1,021 57 5.53
Other borrowed funds...... 674 57 8.46 37 1 3.54
-------- ------- ------ -------- ------- ------
Total interest bearing
liabilities............. 294,649 $13,228 4.49% 326,313 $13,066 4.00%
Demand and other
noninterest bearing
deposits................. 28,932 37,906
Other noninterest bearing
liabilities.............. 6,473 6,712
-------- ------- ------ -------- ------- ------
Stockholders' equity...... 97,041 100,610
-------- ------- ------ -------- ------- ------
Total liabilities and
stockholders' equity.... $427,095 $471,541
======== ======= ====== ======== ======= ======
Net interest income....... $20,144 $23,458
Net interest spread....... 4.03% 4.55%
Net interest margin....... 5.14% 5.49%
Average interest earning
assets to average
interest bearing
liabilities.............. 132.98% 130.83%
- --------
(1) Calculated using average daily balances
27
Six Months Ended December 31,
----------------------------------------------------
1997 1998
------------------------- -------------------------
Average Interest Average Average Interest Average
Balance Earned/ Rate Balance Earned/ Rate
(1) Paid (2) (1) Paid (2)
-------- -------- ------- -------- -------- -------
(Dollars in thousands)
Interest Earning Assets:
Loans..................... $243,745 $11,679 9.58% $319,645 $15,329 9.59%
Mortgage Backed
Securities............... 4,929 208 8.45 3,593 151 8.42
Investment securities and
FHLB stock............... 16,335 486 5.94 46,178 1,186 5.14
Interest earning
deposits................. 15,769 442 5.61 57,248 1,544 5.39
-------- ------- ------ -------- ------- ------
Total interest earning
assets................... 280,778 $12,815 9.13% 426,664 $18,210 8.54%
Noninterest earning
assets................... 26,419 42,719
-------- ------- ------ -------- ------- ------
Total assets............. $307,197 $469,383
======== ======= ====== ======== ======= ======
Interest Bearing
Liabilities:
Certificates of deposit... $146,229 $ 4,088 5.59% $177,956 $ 4,861 5.46%
Savings accounts.......... 41,184 740 3.60 63,986 1,113 3.48
Interest bearing demand
and money market
accounts................. 60,877 972 3.19 82,746 1,165 2.82
-------- ------- ------ -------- ------- ------
Total interest bearing
deposits................ 248,290 5,800 4.67 324,688 7,139 4.40
FHLB advances............. 243 7 6.22 693 22 6.24
Other borrowed funds...... 563 24 8.54 891 32 7.16
-------- ------- ------ -------- ------- ------
Total interest bearing
liabilities............. 249,096 $ 5,832 4.68% 326,272 $ 7,193 4.41%
Demand and other
noninterest bearing
deposits................. 22,211 36,540
Other noninterest bearing
liabilities.............. 4,355 7,210
Stockholders' equity...... 31,536 99,361
-------- ------- ------ -------- ------- ------
Total liabilities and
stockholders' equity.... $307,197 $469,383
======== ======= ====== ======== ======= ======
Net interest income (2)... $ 6,983 $11,017
Net interest spread (2)... 4.45% 4.13%
Net interest margin (2)... 4.97% 5.16%
Average interest earning
assets to average
interest bearing
liabilities.............. 112.72% 130.77%
- --------
(1) Calculated using average daily balances
(2) Annualized
28
Year Ended June 30,
----------------------------------------------------
1997 1998
------------------------- -------------------------
Average Interest Average Interest
Balance Earned/ Average Balance Earned/ Average
(1) Paid Rate (1) Paid Rate
-------- -------- ------- -------- -------- -------
(Dollars in thousands)
Interest Earning Assets:
Loans..................... $213,560 $20,200 9.46% $251,816 $24,053 9.55%
Mortgage Backed
Securities............... 5,598 464 8.29 4,603 397 8.63
Investment securities and
FHLB stock............... 18,172 1,079 5.94 22,808 1,298 5.69
Interest earning
deposits................. 13,631 717 5.26 39,634 2,229 5.62
-------- ------- ------ -------- ------- ------
Total interest earning
assets................... 250,961 $22,460 8.95% 318,861 $27,977 8.77%
Noninterest earning
assets................... 24,416 27,690
-------- --------
Total assets............. $275,377 $346,551
======== ======= ====== ======== ======= ======
Interest Bearing
Liabilities:
Certificates of deposit... $134,226 $ 7,437 5.54% $150,970 $ 8,394 5.56%
Savings accounts.......... 35,269 1,216 3.45 41,863 1,463 3.50
Interest bearing demand
and money market
accounts................. 53,850 1,703 3.16 62,577 1,953 3.12
-------- ------- ------ -------- ------- ------
Total interest bearing
deposits................ 223,345 10,356 4.64 255,410 11,810 4.62
FHLB advances............. 27 1 4.99 156 10 6.09
Other borrowed funds...... 662 60 9.05 572 47 8.25
-------- ------- ------ -------- ------- ------
Total interest bearing
liabilities............. 224,034 $10,417 4.65% 256,138 $11,867 4.63%
Demand and other
noninterest bearing
deposits................. 16,412 22,759
Other noninterest bearing
liabilities.............. 5,195 4,768
Stockholders' equity...... 29,736 62,886
-------- ------- ------ -------- ------- ------
Total liabilities and
stockholders' equity.... $275,377 $346,551
======== ======= ====== ======== ======= ======
Net interest income....... $12,043 $16,110
Net interest spread....... 4.30% 4.14%
Net interest margin....... 4.80% 5.05%
Average interest earning
assets to average
interest bearing
liabilities.............. 112.02% 124.49%
- --------
(1) Calculated using average daily balances
29
The following table sets forth the amount of change in our net interest
income attributable to changes in volume and changes in interest rates.
Changes attributable to the combined effect of volume and interest rates have
been allocated proportionately to changes due to volume and the changes due to
interest rates.
Year to Date Ended
December 31, 1998
Compared to 1999
Increase(Decrease) Due to
----------------------------
Volume Rate Total
--------- -------- --------
Interest Earning Assets:
Loans............................................ $ 6,824 $ (1,641) $ 5,183
Mortgage backed securities....................... (100) (13) (113)
Investment securities and FHLB stock............. 344 248 592
Interest earning deposits........................ (2,296) (214) (2,510)
-------- -------- --------
Total interest income........................... 4,772 (1,620) 3,152
======== ======== ========
Interest bearing liabilities:
Certificates of deposit.......................... 73 824 897
Savings accounts................................. (525) 82 (443)
Interest bearing demand and money market
accounts........................................ (519) 206 (313)
-------- -------- --------
Total interest bearing deposits................. (971) 1,112 141
FHLB advances.................................... (36) 1 (35)
Other borrowings................................. 54 2 56
-------- -------- --------
Total interest bearing liabilities.............. $ (953) $ 1,115 $ 162
======== ======== ========
Six Months Ended
December 31, 1997
Compared to 1998
Increase(Decrease) Due to
----------------------------
Volume Rate Total
--------- -------- --------
Interest Earning Assets:
Loans............................................ 3,637 13 3,650
Mortgage backed securities....................... (56) (1) (57)
Investment securities and FHLB stock............. 886 (186) 700
Interest earning deposits........................ 1,164 (62) 1,102
-------- -------- --------
Total interest income........................... 5,631 (236) 5,395
======== ======== ========
Interest bearing liabilities:
Certificates of deposit.......................... (887) 113 (774)
Savings accounts................................. (410) 37 (373)
Interest bearing demand and money market
accounts........................................ (349) 157 (192)
-------- -------- --------
Total interest bearing deposits................. (1,646) 307 (1,339)
FHLB advances.................................... (14) -- (14)
Other borrowings................................. (14) 6 (8)
-------- -------- --------
Total interest bearing liabilities.............. (1,674) 313 (1,361)
======== ======== ========
30
Year Ended June 30, 1997
Compared to 1998
Increase(Decrease) Due to
----------------------------
Volume Rate Total
--------- ------- ---------
Interest Earning Assets:
Loans............................................ $ 3,619 $ 234 $ 3,853
Mortgage backed securities....................... (82) 15 (67)
Investment securities and FHLB stock............. 275 (56) 219
Interest earning deposits........................ 1,368 144 1,512
--------- ------ ---------
Total interest income........................... $ 5,180 $ 337 $ 5,517
========= ====== =========
Interest bearing liabilities:
Certificates of deposit.......................... $ (928) $ (29) $ (957)
Savings accounts................................. (227) (20) (247)
Interest bearing demand deposits................. (276) 26 (250)
--------- ------ ---------
Total interest on deposits...................... (1,431) (23) (1,454)
FHLB advances.................................... (7) (2) (9)
Other borrowed funds............................. 8 5 13
--------- ------ ---------
Total interest expense.......................... $ (1,430) $ (20) $ (1,450)
========= ====== =========
Financial Condition
Our total assets grew $35.1 million (7.4%) to $511.0 million at December 31,
1999 from $475.9 million at December 31, 1998. The asset growth corresponds
with deposit growth of $38.1 million (10.4%) to $405.1 million at December 31,
1999 from $367.0 million at December 31, 1998. Total loans grew by
$90.8 million (27.8%) to $417.7 million at December 31, 1999 from $327.0
million at December 31, 1998. $63.9 million (70.4%) of the loan growth was in
commercial loans as they grew to $192.1 million at December 31, 1999 from
$128.2 million at December 31, 1998, an increase of 49.9%.
On April 26, 1999 our board of directors authorized the repurchase in the
open market of 100,000 of our shares. This was accomplished in the second
quarter for $0.8 million, or $8.56 per share. On October 22, 1999 we announced
our intention to repurchase up to 10% of our outstanding common shares, or
approximately 1.1 million shares. During the fourth quarter of 1999, we
repurchased 821,050 shares, representing 7.5% of the 10.0% of stock intended
to be repurchased for $7.0 million at an average price of $8.55 per share.
Subsequent to year ending December 31, 1999, on February 18, 2000, we
announced the repurchase of an additional 10%, or approximately 975,000
shares. The additional share repurchase will take place over the next 18
months.
Results of Operations for the Years Ended December 31, 1999 and 1998
Net Income. Our net income was $5.4 million or $0.49 per diluted share for
the year ended December 31, 1999 as compared to $4.9 million or $0.44 per
diluted share for the same period last year. The 1998 amounts include merger
related charges of $748,000 on a pre-tax basis. Excluding these charges, net
income for the twelve months ended December 31, 1998 was $5.3 million or $0.48
per diluted share. These nonrecurring charges were related to severance and
other costs associated with the merger and integration of North Pacific Bank
into Heritage Bank in November 1998, costs associated with the formerly
proposed acquisition of Harbor Bancorp which was terminated by mutual
agreement in December 1998, and costs associated with the then pending
acquisition of Washington Independent, which was completed March 5, 1999 and
accounted for as a pooling of interests.
Net Interest Income. Net interest income increased $3.3 million, or 16.4%,
for the year ended December 31, 1999 compared with the same period last year,
primarily as a result of the $71.4 million (24.6%) increase in the average
balance of loans which was heavily concentrated in commercial loans. Average
interest earning assets grew $35.1 million as average interest earning short
term investments (primarily deposits) decreased by $41.6 million to fund loan
growth.
31
Net interest income as a percentage of average interest earning assets (net
interest margin) for the year ended December 31, 1999 increased to 5.49% from
5.14% for the same period last year. The increase was the result of strong
growth in commercial loans which have higher yields and a shift away from
overnight funds repossessed from the $63 million in net proceeds from the
January 1998 stock offering. Our net interest spread for the year ended
December 31, 1999 has increased to 4.55% from 4.03% for the prior year as a
result of the decrease in the average cost of funds to 4.00% for the year
ended December 31, 1999 from 4.49% for the same period last year. This
resulted from our efforts, particularly during 1998 at lowering the cost of
deposits. Although retail deposit balances declined, it had its desired effect
on our cost of funds.
Provision for Loan Losses. During the year ended December 31, 1999,we
provided $408,000 through operations to maintain our allowance for loan losses
at an adequate level during a time of change in loan portfolio composition and
loan growth. In the year ended December 31, 1999, we experienced net charge-
offs of $101,000. While our loan portfolio, and in particular commercial
loans, have grown substantially over the past three years, our asset quality
has remained very solid as demonstrated by the nonperforming assets to total
assets ratio of 0.35% at December 31, 1999. Because commercial business
lending generally involves greater risk than those associated with residential
and commercial real estate lending, we have increased the portion of our
general allowance for loan losses allocated to our commercial loans over the
past three years.
We consider the allowance for loan losses at December 31, 1999 to be
adequate to cover reasonably foreseeable loan losses based on our assessment
of various factors affecting the loan portfolio, including the level of
problem loans, business conditions, estimated collateral values, loss
experience and credit concentrations.
Noninterest Income. Total noninterest income decreased $1.1 million (21.8%)
for the year ended December 31, 1999 compared with the prior year. The decline
is attributable to the region wide reduction in the level of mortgage banking
activity particularly for refinanced mortgages. Loan sale gains fell $1.5
million to $1.1 million for 1999 from $2.6 million in 1998, a decline of
58.5%. Total mortgage production of $78.2 million during the year ended
December 31, 1999 was down from the prior year production of $132.2 million by
$54.0 million (40.8%).
Noninterest Expense. Total noninterest expense increased $1.3 million (7.5%)
for the year ended 1999 compared to the 1998 period. 1998 included $748,000 in
charges related to severance and other costs associated with the merger and
integration of North Pacific Bank into Heritage Bank in November 1998, costs
associated with the formerly proposed acquisition of Harbor Bancorp terminated
by mutual agreement in December 1998 and costs associated with the then
pending acquisition of Washington Independent. Excluding these non recurring
charges from 1998, noninterest expense increased $2.1 million (11.8%)
primarily in the areas of salaries and benefits, occupancy, amortization of
goodwill and other expenses related to the strengthening of our capabilities
in commercial lending, plus a full year's impact of North Pacific Bank's
operations which had impacted only the second half of 1998. Our efficiency
ratio for 1999 was 68.27%, compared with 69.02% for the same twelve month
period in 1998.
Results of Operations for the Six Month Periods Ended December 31, 1998 and
1997
Net Income. Our net income before merger related charges was $2.7 million or
$0.24 per diluted share for the six months ended December 31, 1998 as compared
to $1.6 million or $0.15 per diluted share for the same period in 1997.
Including merger related charges of $748,000 on a pre-tax basis, net income
for the six months ended December 31, 1998 was $2.2 million or $0.20 per
diluted share. These nonrecurring charges were related to severance and other
costs associated with the merger and integration of North Pacific Bank into
Heritage Bank in November 1998, costs associated with the formerly proposed
acquisition of Harbor Bancorp which was terminated by mutual agreement in
December 1998, and costs associated with the pending acquisition of Washington
Independent, which was completed on March 5, 1999 and accounted for as a
pooling of interests.
Net Interest Income. Net interest income increased $4.0 million, or 57.7%,
for the six months ended December 31, 1998 compared with the same period in
1997, primarily as a result of a $145.9 million increase in the average
balance of interest earning assets. This growth in interest earning assets was
attributable to
32
$68.9 million in interest earning assets acquired through North Pacific Bank
in June 1998 and the interest earning assets funded by the $63 million in net
proceeds raised in our January 1998 stock offering. Average loan balances
increased $75.9 million, or 31.1%, which was concentrated in commercial loans.
Net interest income as a percentage of average interest earning assets (net
interest margin) annualized for the six months ended December 31, 1998
increased to 5.16% from 4.97% for the same period in 1997. The increase was
the result of strong growth in commercial loans which have higher yields and a
lower cost funding mix attributable to the $63 million in net proceeds from
our January 1998 stock offering and the addition of lower cost deposits
acquired with North Pacific Bank. The significant shift in our funding mix is
demonstrated in our ratio of average interest earning assets to average
interest bearing liabilities which increased to 130.77% for the six months
ended December 31, 1998 from 112.72% for the same period in 1997. This ratio
indicates that we are funding more of our earning asset growth with
noninterest bearing funds (capital and noninterest bearing deposits). Our net
interest spread annualized for the six months ended December 31, 1998 declined
to 4.13% from 4.45% for the same period in 1997 as a result of the decrease in
the average yield on earning assets to 8.54% for the six months ended December
31, 1998 from 9.13% for the same period last year. The increase in the average
balances of investment securities and interest earning deposits at yields
significantly below the average earning asset yield, as well as the decline in
market interest rates, had the effect of decreasing the overall earning asset
yield for the six months ended December 31, 1998.
Provision for Loan Losses. During the six months ended December 31, 1998, We
provided $202,000 through operations to maintain our allowance for loan losses
at an adequate level during a time of change in loan portfolio composition and
loan growth. In the six months ended December 31, 1998, we experienced net
charge-offs of $174,000, most of which were related to loans originated and
classified by North Pacific Bank prior to our acquisition of North Pacific
Bank in June 1998. While our loan portfolio, and in particular commercial
loans, have grown substantially from 1995 to 1998, our asset quality remained
very solid as demonstrated by the nonperforming assets to total assets ratio
of 0.08% at December 31, 1998. Because commercial business lending generally
involves greater risk than those associated with residential and commercial
real estate lending, we increased the portion of our general allowance for
loan losses allocated to our commercial loans during those years.
We considered the allowance for loan losses at December 31, 1998 to be
adequate to cover reasonably foreseeable loan losses based on our assessment
of various factors affecting the loan portfolio, including the level of
problem loans, business conditions, estimated collateral values, loss
experience and credit concentrations.
Noninterest Income. Total noninterest income increased $903,000, or 45.2%,
for the six months ended December 31, 1998 compared with the same period in
1997. This increase was primarily due to increases in gains on sales of loans,
service charges on deposits and other income. Gains on sales of loans
increased $195,000, or 17.7% for the 1998 period compared to the same period
in 1997 due to the 27.2% increase in the volume of mortgage loans sold in the
1998 period. Service charges on deposits increased $228,000, or 52.7%, as a
result of growth in business and personal checking accounts. Other income
increased $446,000, or 157.0%, for the 1998 period due to $120,000 in fees
from vehicle licensing activities (performed by a former subsidiary of North
Pacific Bank) as well as increases in the volume of loan servicing fees and
merchant card processing fees.
Noninterest Expense. Total noninterest expense increased $3.8 million, or
58.1%, for the 1998 period compared to the 1997 period. This $3.8 million
increase included $748,000 in merger related charges related to severance and
other costs associated with the merger and integration of North Pacific Bank
into Heritage Bank in November 1998, costs associated with the formerly
proposed acquisition of Harbor Bancorp which was terminated by mutual
agreement in December 1998 and costs associated with the then pending
acquisition of Washington Independent. Excluding merger related charges,
noninterest expense increased $3.2 million, or 50.5%, primarily in the areas
of salaries and employee benefits, occupancy, amortization of goodwill and
other noninterest expenses due to the impact of the acquisition and
integration of the operations of North Pacific Bank. Total noninterest expense
(adjusted for the nonrecurring merger related charges) was 69.5% of total
revenue (the sum of net interest income and noninterest income) for the six
months ended December 31, 1998 as compared to 72.9% for the six months ended
December 31, 1997.
33
Results of Operations for the Years Ended June 30, 1998 and 1997
Net Income. Our earnings increased to $4.3 million, or $0.40 per diluted
share, for the year ended June 30, 1998, compared with $2.6 million, or $0.24
per diluted share, for the same period in 1997, an increase of 63.9%. The
increase in net income was primarily attributable to a $67.9 million increase
in the average balance of earning assets and a widening of the net interest
margin. The majority of the increase in earning assets and the widening of the
net interest margin was the result of the large influx of equity capital ($63
million) from our January 1998 stock offering.
Net Interest Income. Net interest income increased $4.1 million, or 33.7% in
1998 compared to 1997, primarily as a result of a $67.9 million increase in
the average balance of interest earning assets. This growth in interest
earning assets was funded by the $63.0 million in net proceeds raised in our
January 1998 stock offering. Average loan balances increased $38.3 million, or
17.9%, which was concentrated in commercial loans with higher yields.
Net interest income as a percentage of average interest earning assets (net
interest margin) for 1998 increased to 5.05% from 4.80% in 1997. The increase
was primarily attributable to growth in earning assets combined with a
significant shift in our funding mix due to the funds raised in our stock
offering. This is demonstrated by the increase in our ratio of average
interest earning assets to average interest bearing liabilities to 124.49% for
1998 from 112.02% for 1997 which indicates that we are funding more of our
earning asset growth with non-interest bearing funds (capital and noninterest
bearing deposits). Our net interest spread for 1998 declined to 4.14% from
4.30% for 1997 as a result of the decrease in the average yield on earning
assets to 8.77% for 1998 from 8.95% for 1997. Although the average yield on
loans increased to 9.55% for 1998 from 9.46% for 1997 due primarily to the
growth in commercial loans with higher yields, the increase in the average
balances of investment securities and interest earning deposits at yields
significantly below the average earning asset yield had the effect of
decreasing the overall earning asset yield for 1998.
Provision for Loan Losses. During 1998, we provided $149,000 through
operations to maintain our allowance for loan losses at an adequate level
during a time of change in loan portfolio composition and loan growth. In
1997, we recorded a $1.2 million recovery on a multifamily mortgage loan which
had been partially charged off in a prior year. In reviewing the adequacy of
our allowance for loan losses as of June 30, 1997, we determined that the
allowance balance was more than adequate to cover any potential losses in our
loan portfolio and therefore reduced the allowance balance through a $265,000
negative provision for loan losses.
We considered the allowance for loan losses at June 30, 1998 to be adequate
to cover reasonably foreseeable loan losses based on our assessment of various
factors affecting the loan portfolio, including the level of problem loans,
business conditions, estimated collateral values, loss experience and credit
concentrations.
Noninterest Income. Total noninterest income increased $513,000, or 13.7%,
for 1998 compared with 1997 primarily due to the $400,000, or 19.9%, increase
in gains on sales of loans for 1998. The increase in gains on sales of loans
was attributable to the 17.1% increase in the volume of mortgages sold ($101.9
million for 1998 compared to $87.0 million for 1997) and the 14.0% increase in
residential mortgage loan originations for 1998 compared to 1997.
Commissions on sales of annuities and securities decreased $69,000, or
31.4%, as a result of lower sales volume due to staff turnover. Service
charges on deposits increased $157,000, or 19.8%, due to growth in personal
and business checking accounts. Other income increased $27,000, or 5.2%, for
1998 due to increases in the volume of fees related to merchant credit card
processing and customer check ordering activity.
Noninterest Expense. Total noninterest expense decreased $244,000, or 0.2%,
in 1998 compared with 1997. Excluding the $1.1 million special SAIF assessment
in 1997, noninterest expense in 1998 increased $1.3 million, or 10.9%,
compared with adjusted 1997 expense levels. The increase in noninterest
expenses during 1998 were concentrated in data processing and marketing
expenses and represent a continuation of our
34
implementation of our growth strategy, specifically, geographical and product
expansion, development of relationship banking and loan portfolio
diversification. We have developed business checking accounts and commercial
lending products and services for businesses and their owners; introduced
credit and debit cards; installed an automated response system for customer
account inquiries and developed products to assist realtors and potential
borrowers to obtain information about loan programs. Total noninterest expense
was 66.70% of total revenue (the sum of net interest income and noninterest
income) for the year ended June 30, 1998 as compared to 76.89% (adjusted for
the nonrecurring SAIF assessment) for 1997.
Salaries and employee benefits increased $695,000, or 10.2%, for 1998 as a
result of increases in mortgage commissions, salaries and benefits related to
North Pacific Bank employees for June 1998 and increases in payroll taxes,
health insurance and other employee benefits. Mortgage commissions increased
$146,000, or 21.3%, due to the increased volume of residential mortgage loans
originated and the increased proportion of that volume produced by
commissioned loan officers. The increases in data processing, marketing and
other expenses were due to our implementation of our growth strategy as
described in the paragraph above.
Liquidity and Capital Resources
Our primary sources of funds are deposits, loan repayments, loan sales,
maturing investment securities and advances from the 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 to 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, to
satisfy other financial commitments and to fund operations. We generally
maintain sufficient cash and short term investments to meet short term
liquidity needs. At December 31, 1999 cash and cash equivalents totaled $20.6
million, or 4.0% of total assets. At December 31, 1999, Heritage Bank
maintained a credit facility with the FHLB of Seattle for $89.2 million (of
which only $2.8 million was outstanding at that date).
To fund growth in 1999, our strategy has been to acquire core deposits
(which we define to include all deposits except public funds) from our retail
accounts, non interest bearing demand deposits from our commercial customers
and public funds from the State of Washington. Total deposits increased $38.1
million, or 10.4%, to $405.1 million at December 31, 1999 from $367.0 million
at December 31, 1998. The largest increase in deposits occurred in public
funds which grew $49.3 million. In the month of December we increased our
public deposit totals to give us additional short term funds to provide for
exigencies over the Y2K year end. Year to year non-interest bearing demand
deposits grew by $4.0 million while all other deposits declined by $15.2
million. The decline in all other deposits occurred primarily in retail time
certificates of deposit which management made a conscious decision in the
first half of year to price less aggressively expecting to incur runoff. We
anticipate that we will continue to rely on the same sources of funds in the
future and will use those funds primarily to make loans and purchase
investment securities. Loan growth was also funded in 1999 through a reduction
in cash (cash on hand and in banks, interest earning overnight deposits, and
federal funds sold) of $50.3 million or 70.9% to $20.6 million at December 31,
1999 from $70.6 million at December 31, 1998.
We and our banks are subject to various regulatory capital requirements. As
of December 31, 1999, we and our banks were classified as "well capitalized"
institutions under the criteria established by the FDIC Act. As of June 30,
1997 , 1998, and December 31, 1998 Heritage Bank was also classified as a
"well capitalized" institution.
Asset/Liability Management
Our primary financial objective is to achieve long term profitability while
controlling our exposure to fluctuations in market interest rates. To
accomplish this objective, we have formulated an interest rate risk
35
management policy that attempts to manage the mismatch between asset and
liability maturities while maintaining an acceptable interest rate sensitivity
position. The principal strategies which we employ to control our interest
rate sensitivity are: the sale of most long term, fixed rate, one- to four-
family residential mortgage loan originations; the origination of commercial
loans and residential construction loans at variable interest rates for terms
generally one year or less; and offering noninterest bearing demand deposit
accounts to businesses and individuals. The longer term objective is to
increase the proportion of noninterest bearing demand deposits, interest
bearing demand deposits and money market accounts and savings deposits
relative to certificates of deposit thereby reducing interest sensitivity and
risk
Our asset and liability management strategies have resulted in a modest
positive "gap" of 1.83% for the 0-3 month period and an equally modest
negative one year "gap" of (1.66)% as of December 31, 1999. These "gaps"
measure the difference between the dollar amount of our interest earning
assets and interest bearing liabilities that mature or reprice within the
designated period (0-3 months and one year) as a percentage of total interest
earning assets, based on certain estimates and assumptions as discussed below.
The acquisition of North Pacific Bank accelerated our progress toward our
objective of achieving balance by adding more variable rate commercial loans
to our loan portfolio and reducing the percentage of certificates of deposit
to total deposits from 60.4% as of June 30, 1997 to 47.9% as of December 31,
1998 with a small increase to 49.2% as of December 31, 1999. We believe that
the implementation of our operating strategies has reduced the potential
effects of changes in market interest rates on our results of operations. The
continuing positive gap for the 0-3 month period indicates that decreases in
market interest rates may adversely affect our results in the near term.
36
The following table sets forth the estimated maturity or repricing and the
resulting interest rate sensitivity gap of our interest earning assets and
interest bearing liabilities at December 31, 1999 based upon estimates of
expected mortgage prepayment rates and deposit decay rates consistent with
national trends. We have adjusted mortgage loan maturities for loans held for
sale by reflecting these loans in the zero to three month category which is
consistent with their sale in the secondary mortgage market. The amounts in
the table are derived from our internal data, and because certain assumptions
have been utilized in presenting this data, the amounts may not be consistent
with financial information appearing elsewhere in this document that have been
prepared in accordance with generally accepted accounting principles. The
amounts in the tables also could be significantly affected by external
factors, such as changes in prepayment assumptions, early withdrawal of
deposits and competition.
Estimated Maturity or Repricing Within
----------------------------------------------------------
0-3 4-12 1-5 5-10 More than
months months years years 10 years Total
-------- -------- -------- ------- --------- --------
(Dollars in thousands)
Interest Earnings
Assets:
Loans................... $147,213 $ 83,644 $ 98,626 $64,884 $23,392 $417,759
Investment securities... 582 3,300 34,135 2,606 2,420 43,043
FHLB stock.............. 2,218 -- -- -- -- 2,218
Fed funds sold.......... 2,100 -- -- -- -- 2,100
Interest earning
deposits............... 3 -- -- -- -- 3
-------- -------- -------- ------- ------- --------
Total interest earning
assets................. $152,116 $ 86,944 $132,761 $67,490 $25,812 465,123
Noninterest earning
assets................. 45,835
-------- -------- -------- ------- ------- --------
Total assets........... $510,958
======== ======== ======== ======= ======= ========
Interest Bearing
Liabilities:
Total interest bearing
deposits............... 140,805 103,197 114,952 -- -- 358,954
FHLB advances and other
borrowings............. 2,800 -- 7 -- -- 2,807
-------- -------- -------- ------- ------- --------
Total interest bearing
liabilities............ $143,605 $103,197 $114,959 $ -- $ -- $361,761
Noninterest bearing
liabilities and equity 149,197
-------- -------- -------- ------- ------- --------
Total liabilities and
equity................ $510,958
======== ======== ======== ======= ======= ========
Rate sensitivity gap.... $ 8,511 $(16,253) $ 17,802 $67,490 $25,812 $103,362
Cumulative rate
sensitivity gap:
Amount.................. 8,511 (7,742) 10,060 77,550 103,362
As a percentage of
interest earning
assets................. 1.83% (1.66)% 2.16% 16.67% 22.22%
======== ======== ======== ======= ======= ========
Certain shortcomings are inherent in the method of analysis presented in the
foregoing table. For example, although certain assets and liabilities may have
similar maturities or periods to repricing, they may react in different
degrees to changes in market interest rates. Also, the interest rates on some
types of assets and liabilities may fluctuate in advance of changes in market
interest rates, while interest rates on other types may lag behind changes in
market interest rates. Additionally, some assets, such as adjustable rate
mortgages, have features which restrict changes in the interest rates of those
assets both on a short term basis and over the lives of such assets. Further,
in the event of a change in market interest rates, prepayment and early
withdrawal levels could deviate significantly from those assumed in
calculating the tables. Finally, the ability of many borrowers to service
their adjustable rate debt may decrease in the event of a substantial increase
in market interest rates.
Year 2000 Issues
We utilize various computer software programs to provide banking products
and services to our customers. Many existing computer programs used only two
digits to identify a year in the date field and were not designed to consider
the impact of the change in the century. If not corrected, many computer
applications could have failed or created erroneous results on or at the Year
2000. The Year 2000 issue affected virtually all companies and organizations.
We spent approximately $315,000 analyzing, testing, upgrading systems, and
planning for possible contingencies to assure our customers, stockholders, and
the general public that we would be able to facilitate
37
the delivery of our financial services. As a result of these efforts, we
experienced no events, major or otherwise, related to the programming problem.
Impact of Inflation and Changing Prices
The primary impact of inflation on our operations is increased operating
costs. Unlike most industrial companies, virtually all the assets and
liabilities of a financial institution are monetary in nature. As a result,
interest rates generally have a more significant impact on a financial
institution's performance than the effects of general levels of inflation.
Although interest rates do not necessarily move in the same direction or to
the same extent as the prices of goods and services, increases in inflation
generally have resulted in increased interest rates.
Recent Financial Accounting Pronouncements
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" This statement establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. In May 1999, the Financial Accounting
Standards Board delayed the effective date of SFAS No. 133 to fiscal years
beginning after June 15, 2000, with interim reporting required. We do not
expect that application of this statement will have a material effect on our
results of operations or the financial position.
In October 1998, the FASB issued SFAS No. 134 (which amended Statement No.
65), "Accounting for Certain Mortgage Banking Activities." This statement
establishes accounting and reporting standards for securities retained after
the securitization of mortgage loans and was adopted by us on January 1, 1999.
The adoption of SFAS No. 134 did not have a material impact on our financial
position or results of operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to interest rate risk through our lending and deposit
gathering activities. For a discussion of how this exposure is managed and the
nature of changes in our interest rate risk profile during the past year,
see "Asset/Liability Management."
Neither we nor our banks maintain a trading account for any class of
financial instrument, nor do we or they engage in hedging activities or
purchase high risk derivative instruments. Moreover, neither we nor our banks
are subject to foreign currency exchange rate risk or commodity price risk.
38
The table below provides information as of December 31, 1999 about our
financial instruments that are sensitive to changes in interest rates. The
table presents principal cash flows and related weighted average interest
rates by expected maturity dates. The data in this table may not be consistent
with the amounts in the preceding table which represents amounts by the
repricing date or maturity date (whichever occurs sooner) adjusted by
estimates such as mortgage prepayments and deposit decay or early withdrawal
rates.
By Expected Maturity Date
----------------------------------------------------------------
Year Ended December 31,
----------------------------------------------------------------
2003- After Fair
2000 2001 2002 2004 2005 Total Value
-------- ------- ------- ------- -------- -------- --------
(Dollars in thousands)
Investment Securities
Amounts maturing:
Fixed rate............ $ 3,284 $16,497 $10,710 $ 5,800 $ 6,217 $ 42,508
Weighted average
interest rate........ 6.03% 5.44% 5.74% 6.22% 7.31%
Adjustable Rate....... 35 -- -- -- -- 35
Weighted average
interest rate........ 7.50% -- -- -- --
-------- ------- ------- ------- -------- -------- --------
Totals.............. 3,319 16,497 10,710 5,800 6,217 $ 42,543 $ 42,597
Loans
Amounts maturing:
Fixed rate............ $ 27,605 $ 6,943 $ 4,527 $21,386 $133,955 $194,416
Weighted average
interest rate........ 9.17% 9.20% 8.89% 8.78% 8.10%
Adjustable rate....... 113,427 12,058 13,444 65,764 18,652 223,345
Weighted average
interest rate........ 9.23% 8.98% 8.62% 8.21% 8.03%
-------- ------- ------- ------- -------- -------- --------
Totals.............. $141,032 $19,001 $17,971 $87,150 $152,607 $417,761 $417,313
Certificates of Deposit
Amounts maturing:
Fixed rate............ $184,892 $12,984 $ 703 $ 1,818 $ -- $200,397 $199,719
Weighted average
interest rate........ 5.25% 5.42% 4.53% 4.86% --
FHLB Advances
Amounts maturing:
Fixed rate............ $ 2,800 $ -- $ -- $ -- $ -- $ 2,800 $ 2,800
Weighted average
interest rate........ 5.70% -- -- -- --
Other Borrowings
Amounts maturing:
Fixed rate............ $ 7 $ -- $ -- -- -- $ 7 $ 7
Weighted average
interest rate........ 0.00% -- -- -- --
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
For financial statements, see Index to Consolidated Financial Statements on
page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
39
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information concerning directors of the registrant is incorporated herein by
reference to the section entitled "Election of Directors" of the Company's
definitive Proxy Statement dated March 22, 1999 (the "Proxy Statement") for
the annual meeting of shareholders to be held May 1, 2000.
The required information with respect to the executive officers of the
Company is incorporated herein by reference to the section entitled "Executive
Officers" of the Proxy Statement.
The required information with respect to compliance with Section 16(a) of
the Exchange Act is incorporated herein by reference to the section entitled
"Section 16(a) Beneficial Ownership Reporting Compliance" of the Proxy
Statement.
ITEM 11. EXECUTIVE COMPENSATION
For information concerning executive compensation see "Executive
Compensation" of the Proxy Statement, which is incorporated herein by
reference. Neither the Report of the Personnel and Compensation Committee nor
the Stock Performance Graph, both of which are contained in the Proxy
statement, are incorporated by this reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
For information concerning security ownership of certain beneficial owners
and of management see "Security Ownership of Management" of the Proxy
Statement, which is incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
For information concerning certain relationships and related transactions,
see "Interest of Management in Certain Transactions" of the Proxy Statement,
which is incorporated herein by reference.
40
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) The consolidated financial statements are contained herein as listed
on the "Index to Consolidated Financial Statements" on page F-1 hereof.
(2) All schedules are omitted because they are not required or
applicable, or the required information is shown in the consolidated
financial statements or the notes thereto.
(3) Exhibits
Exhibit
No.
-------
3.1 Articles of Incorporation (1)
3.2 Bylaws of the Company (1)
10.1 1998 Stock Option and Restricted Stock Award Plan (2)
Employment Agreement between the Company and Donald V. Rhodes,
10.2 effective October 1, 1997. (1)
Severance Agreement between the Company and Brian L. Vance, effective
10.3 October 1, 1997. (1)
Severance Agreement between the Company and John D. Parry, effective
10.4 October 1, 1997(1)
10.5 Form of Severance Agreement entered into between the Company and seven
additional executives, effective as of October 1, 1997. (1)
10.6 1997 Stock Option and Restricted Stock Award Plan (3)
21.0 Subsidiaries of the Company
23.0 Consent of KPMG LLP
24.0 Power of Attorney dated February 17, 2000
27.0 1999 Financial Data Schedule
- --------
(1) Incorporated by reference to the Registration Statement on Form S-1 (Reg.
No. 333-35573) declared effective on November 12, 1997.
(2) Incorporated by reference to the definitive Proxy Statement dated September
14, 1998 for the Annual Meeting of Shareholders held on October 15, 1998.
(3) Incorporated by reference to the Registration Statement on Form S-8 (Reg.
No. 333-57513).
(b) Reports on Form 8-K. The Company filed two reports on Form 8-K between
October 1, 1999 and December 31, 1999 as follows:
(1) October 22, 1999 Form 8-K announcing that the board of Heritage
Financial Corporation authorized the repurchase of 10% of its
outstanding stock.
(2) December 15, 1999 Form 8-K announcing that the board of Heritage
Financial Corporation elected Peter Fluetsch to the board
effective December 16, 1999.
41
SIGNATURES
Pursuant to the requirements of Section 13 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.
HERITAGE FINANCIAL CORPORATION
Principal Executive Officer:
/s/ Donald V. Rhodes
-------------------------------------
Donald V. Rhodes
Chairman, President and Chief
Executive Officer
Principal Financial Officer:
/s/ Edward D. Cameron
-------------------------------------
Edward D. Cameron
Vice President and Treasurer
Dated: March 14, 2000
Donald V. Rhodes, pursuant to powers of attorney which are being filed with
this Annual Report on Form 10-K, has signed this report on March 14, 2000, as
attorney-in-fact for the following directors who constitute a majority of the
board of directors.
Lynn M. Brunton John A. Clees
Daryl D. Jensen H. Edward Odegard
James P. Senna Peter Fluetsch
Philip S. Weigand Melvin R. Lewis
/s/ Donald V. Rhodes
-------------------------------------
Donald V. Rhodes
Attorney-in-fact
March 14, 2000
42
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
June 30, 1997, 1998, December 31, 1998, and 1999
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Independent Auditors' Report............................................. F-2
Consolidated Statements of Financial Condition--December 31, 1998 and
December 31, 1999....................................................... F-3
Consolidated Statements of Income--for the years ended June 30, 1997 and
1998 and for the six month periods ended December 31, 1997 (unaudited)
and 1998, and the years ended December 31, 1998 (unaudited) and 1999.... F-4
Consolidated Statements of Stockholders' Equity and Comprehensive
Income--Years ended June 30, 1997 and 1998, for the six months ended
December 31, 1998, and the year ended December 31, 1999................. F-5
Consolidated Statements of Cash Flows--Years ended June 30, 1997 and
1998, for the six month periods ended December 31, 1997 (unaudited) and
1998, and the years ended December 31, 1998 (unaudited) and 1999........ F-6
Notes to Consolidated Financial Statements............................... F-7
F-1
Independent Auditors' Report
The Board of Directors
Heritage Financial Corporation:
We have audited the accompanying consolidated statements of financial
condition of Heritage Financial Corporation and subsidiaries (Corporation) as
of December 31, 1998 and 1999, and the related consolidated statements of
income, stockholders' equity and comprehensive income, and cash flows for each
of the years in the two-year period ended June 30, 1998, for the six-month
period ended December 31, 1998 and for the year ended December 31, 1999.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Heritage Financial Corporation and subsidiaries as of December 31, 1998 and
1999, and the results of their operations and their cash flows for each of the
years in the two-year period ended June 30, 1998, for the six-month period
ended December 31, 1998 and for the year ended December 31, 1999 in conformity
with generally accepted accounting principles.
/s/ KPMG LLP
Seattle, Washington
February 4, 2000
F-2
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31, 1998 and 1999
(Dollars in thousands)
December 31
------------------
1998 1999
--------- -------
ASSETS
------
Cash on hand and in banks.................................. $ 13,793 17,596
Interest earning deposits.................................. 36,355 949
Federal funds sold......................................... 20,800 2,100
Investment securities available for sale................... 31,699 36,378
Investment securities held to maturity..................... 15,897 6,165
Loans held for sale........................................ 7,618 589
Loans receivable........................................... 319,333 417,173
Less: Allowance for loan losses............................ (3,957) (4,264)
--------- -------
Loans, net............................................... 315,376 412,909
Premises and equipment, at cost, net....................... 18,122 18,874
Federal Home Loan Bank stock, at cost...................... 2,062 2,218
Accrued interest receivable................................ 2,735 2,938
Prepaid expenses and other assets.......................... 3,042 2,447
Goodwill................................................... 8,372 7,795
--------- -------
$ 475,871 510,958
========= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Deposits................................................... $ 366,998 405,068
Advances from Federal Home Loan Bank....................... 687 2,800
Other borrowings........................................... 17 8
Advance payments by borrowers for taxes and insurance...... 476 375
Accrued expenses and other liabilities..................... 5,982 6,584
Deferred Federal income taxes.............................. 1,152 859
--------- -------
375,312 415,694
--------- -------
Stockholders' equity:
Common stock, no par, 15,000,000 shares authorized;
10,844,916 and 10,025,407 shares outstanding at December
31, 1998 and December 31, 1999, respectively............ 77,476 69,837
Unearned compensation--ESOP and Other.................... (1,242) (1,154)
Retained earnings, substantially restricted.............. 24,199 26,926
Accumulated other comprehensive income, net.............. 126 (345)
--------- -------
Total stockholders' equity............................. 100,559 95,264
--------- -------
$ 475,871 510,958
========= =======
See accompanying notes to consolidated financial statements.
F-3
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Dollars in thousands, except per share amounts)
Year Ended Six Months Ended Year ended
June 30, December 31, December 31,
----------------------- ---------------------- ----------------------
1997 1998 1997 1998 1998 1999
----------- ---------- ----------- ---------- ---------- ----------
(unaudited) (unaudited)
Interest income:
Loans................. $ 20,200 24,053 11,679 15,329 27,703 32,886
Mortgage backed
securities........... 464 397 208 151 340 227
Investment securities
and Federal Home Loan
Bank dividends....... 1,079 1,298 486 1,186 1,999 2,591
Interest on federal
funds sold and
overnight deposits... 717 2,229 442 1,544 3,330 820
----------- ---------- ---------- ---------- ---------- ----------
Total interest
income............. 22,460 27,977 12,815 18,210 33,372 36,524
----------- ---------- ---------- ---------- ---------- ----------
Interest expense:
Deposits.............. 10,356 11,810 5,800 7,139 13,149 13,008
Other borrowings...... 61 57 32 54 79 58
----------- ---------- ---------- ---------- ---------- ----------
Total interest
expense............ 10,417 11,867 5,832 7,193 13,228 13,066
----------- ---------- ---------- ---------- ---------- ----------
Net interest
income........... 12,043 16,110 6,983 11,017 20,144 23,458
Provision for loan
losses................. (265) 149 71 202 280 408
----------- ---------- ---------- ---------- ---------- ----------
Net interest
income after
provision for
loan losses...... 12,308 15,961 6,912 10,815 19,864 23,050
----------- ---------- ---------- ---------- ---------- ----------
Noninterest income:
Gains on sales of
loans, net........... 2,006 2,406 1,102 1,297 2,601 1,079
Commissions on sales
of annuities and
securities........... 220 151 75 101 178 184
Services charges on
deposits............. 790 947 433 661 1,175 1,378
Rental income......... 210 208 104 112 215 205
Other income.......... 522 549 284 730 996 1,192
----------- ---------- ---------- ---------- ---------- ----------
Total noninterest
income............. 3,748 4,261 1,998 2,901 5,165 4,038
----------- ---------- ---------- ---------- ---------- ----------
Noninterest expense:
Salaries and employee
benefits............. 6,782 7,477 3,677 5,172 8,972 9,616
Building occupancy.... 2,090 2,199 1,077 1,502 2,624 2,870
FDIC premiums and
special assessment... 1,266 141 67 73 147 155
Data processing....... 724 907 425 683 1,165 1,226
Marketing............. 306 431 208 298 522 450
Office supplies and
printing............. 286 312 152 209 370 473
Goodwill
amortization......... -- 12 12 288 288 577
Other................. 1,993 2,211 880 2,050 3,380 3,406
----------- ---------- ---------- ---------- ---------- ----------
Total noninterest
expense............ 13,445 13,690 6,498 10,275 17,468 18,773
----------- ---------- ---------- ---------- ---------- ----------
Income before
Federal income
tax expense
(benefit)........ 2,610 6,532 2,412 3,441 7,561 8,315
Federal income tax
expense (benefit)...... 12 2,273 842 1,275 2,706 2,958
----------- ---------- ---------- ---------- ---------- ----------
Net income........ $ 2,598 4,259 1,570 2,166 4,855 5,357
=========== ========== ========== ========== ========== ==========
Basic earnings per
common share........... $ 0.25 0.41 0.15 0.20 0.46 0.50
Basic weighted average
shares................. 10,226,392 10,394,415 10,235,550 10,553,279 10,663,238 10,763,066
Diluted earnings per
common share........... $ 0.24 0.40 0.15 0.20 0.44 0.49
Diluted weighted average
shares................. 10,742,807 10,669,706 10,253,887 11,029,598 11,059,915 10,935,397
See accompanying notes to consolidated financial statements.
F-4
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE INCOME
(Dollars and shares in thousands)
Unrealized
gain on Total
Number of Additional Unearned securities stock-
common Common paid-in compensation-- Retained available holders'
shares stock capital ESOP and Other earnings for sale equity
--------- ------- ---------- -------------- -------- ---------- --------
Balance at June 30,
1996................... 2,723 $ 8,007 4,068 -- 17,046 41 29,162
Exercise of stock op-
tions.................. 4 4 35 -- -- -- 39
Repurchased shares...... -- (5) -- -- -- -- (5)
Net income.............. -- -- -- -- 2,598 -- 2,598
Net increase in
unrealized gain on
securities available
for sale, net of
taxes.................. -- -- -- -- -- 23 23
Cash dividend declared.. -- -- -- -- (228) -- (228)
------ ------- ------ ------ ------ ---- -------
Balance at June 30,
1997................... 2,727 $ 8,006 4,103 -- 19,416 64 31,589
Offering proceeds....... 6,480 64,352 -- (1,322) -- -- 63,030
Earned ESOP shares...... 4 17 -- 36 -- -- 53
Conversion transaction.. 1,329 4,223 (4,103) -- -- -- 120
Exercise of stock op-
tions.................. 61 141 -- -- -- -- 141
Restricted stock award.. 3 43 -- (43) -- -- --
Net increase in
unrealized gain on
securities available
for sale, net
of taxes............... -- -- -- -- -- 29 29
Net income.............. -- -- -- -- 4,259 -- 4,259
Cash dividend declared.. -- -- -- -- (733) -- (733)
------ ------- ------ ------ ------ ---- -------
Balance at June 30,
1998................... 10,604 76,782 -- (1,329) 22,942 93 98,488
Earned ESOP shares...... 4 11 -- 44 -- -- 55
Exercise of stock op-
tions.................. 240 726 -- -- 11 -- 737
Restricted stock award.. (3) (43) -- 43 -- -- --
Net income.............. -- -- -- -- 2,166 -- 2,166
Net increase in
unrealized gain on
securities available
for sale, net of
taxes.................. -- -- -- -- -- 33 33
Cash dividend declared.. -- -- -- -- (920) -- (920)
------ ------- ------ ------ ------ ---- -------
Balance at December 31,
1998................... 10,845 77,476 -- (1,242) 24,199 126 100,559
Earned ESOP shares...... 9 (13) -- 88 -- -- 75
Exercise of stock op-
tions.................. 92 252 -- -- 19 -- 271
Stock repurchased....... (921) (7,878) -- -- -- -- (7,878)
Net income.............. -- -- -- -- 5,357 -- 5,357
Net increase in
unrealized gain on
securities available
for sale, net of
taxes.................. -- -- -- -- -- (471) (471)
Cash dividend declared.. -- -- -- -- (2,649) -- (2,649)
------ ------- ------ ------ ------ ---- -------
Balance at December 31,
1999................... 10,025 $69,837 -- (1,154) 26,926 (345) 95,264
====== ======= ====== ====== ====== ==== =======
Year ended Six months ended Year ended
June 30, December 31, December 31,
------------ ------------------ -----------------
Comprehensive Income 1997 1998 1997 1998 1998 1999
-------------------- ------ ----- ----------- ------ ---------- -----
(unaudited) (unaudited)
Net income................. $2,598 4,259 1,570 $2,166 4,855 5,357
Increase in unrealized gain
on securities available
for sale, net of tax of
$12, 15, 24, 17,19, and
(243)..................... 23 29 47 33 37 (471)
------ ----- ----- ------ ----- -----
Comprehensive income....... $2,621 4,288 1,617 2,199 4,892 4,886
====== ===== ===== ====== ===== =====
See accompanying notes to consolidated financial statements.
F-5
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Year Ended Six Months Ended Year Ended
June 30, December 31, December 31,
---------------- ------------------- -------------------
1997 1998 1997 1998 1998 1999
------- ------- ----------- ------- ---------- -------
(unaudited) (unaudited)
Cash flows from
operating activities:
Net income............ $ 2,598 4,259 1,570 2,166 4,855 5,357
Adjustments to
reconcile net income
to net cash
provided by operating
activities, net of
effect of
acquisition:
Depreciation and
amortization........ 1,167 1,195 595 790 1,196 2,267
Deferred loan fees,
net of
amortization........ 11 (149) (38) (124) (234) (193)
Provision for loan
losses.............. (265) 149 71 202 280 408
Net decrease
(increase) in loans
held for sale....... (1,036) (89) 1,280 (1,206) (2,575) 7,029
Deferred Federal
income tax expense
(benefit)........... (515) (3) (43) (144) (121) (53)
Federal Home Loan
Bank stock
dividends........... (111) (130) (62) (78) (147) (156)
Recognition of
compensation related
to ESOP............. -- -- -- 55 26 75
Net change in accrued
interest receivable,
prepaid expenses and
other assets, and
accrued expenses and
other liabilities... (229) 2,577 (1,209) 460 1,182 444
------- ------- ------ ------- ------- -------
Net cash provided by
operating
activities......... 1,620 7,809 2,164 2,121 4,462 15,178
------- ------- ------ ------- ------- -------
Cash flows from
investing activities,
net of effect of
acquisition:
Loans originated, net
of principal payments
and loan sales....... (41,967) (21,513) (8,610) (12,417) (25,409) (97,747)
Proceeds from the sale
of real estate
owned................ 75 -- -- -- -- --
Maturities of
investment securities
available for sale... -- 512 -- 4,069 6,465 8,860
Maturities of
investment securities
held to maturity..... 11,485 10,881 4,752 19,351 25,289 10,005
Purchase of investment
securities held to
maturity............. (5,910) (21,147) (1,950) (1,301) (20,311) (265)
Purchase of investment
securities available
for sale............. -- (3,830) (500) (23,073) (28,281) (14,258)
Purchase of premises
and equipment........ (2,125) (712) (193) (807) (1,142) (2,441)
Cash acquired, net of
cash paid for
acquisition.......... -- 10,573 -- -- 10,573 --
------- ------- ------ ------- ------- -------
Net cash used in
investing
activities.......... (38,442) (25,236) (6,501) (14,178) (32,816) (95,846)
------- ------- ------ ------- ------- -------
Cash flows from
financing activities,
net of effect of
acquisition:
Net increase
(decrease) in
deposits............. 27,072 27,215 19,234 3,576 (60,950) 37,964
Net increase
(decrease) in FHLB
advances............. 890 (192) (890) (11) 687 2,113
Net increase
(decrease) in other
borrowed funds....... 525 (537) (74) (1,340) (1,814) (9)
Net increase
(decrease) in advance
payments by borrowers
for taxes and
insurance............ (61) -- -- 57 2 (101)
Cash dividends paid... (228) (342) -- (831) (1,173) (2,438)
Issuance of restricted
stock award and
exercise of stock
options.............. 39 141 34 726 834 271
Proceeds received and
held for stock
conversion........... -- -- 72,506 --
HFC Stock
repurchased.......... (5) (7,435)
Net proceeds from
stock offering....... -- 63,030 -- -- 63,030
------- ------- ------ ------- ------- -------
Net cash provided by
(used in) financing
activities.......... 28,232 89,315 90,810 2,177 616 30,365
------- ------- ------ ------- ------- -------
Net increase
(decrease) in cash
and cash
equivalents......... (8,590) 71,888 86,473 (9,880) (27,738) (50,303)
Cash and cash
equivalents at
beginning of year..... 20,803 12,213 12,213 80,828 98,686 70,948
------- ------- ------ ------- ------- -------
Cash and cash
equivalents at end of
year.................. $12,213 84,101 98,686 70,948 70,948 20,645
======= ======= ====== ======= ======= =======
Supplemental
disclosures of cash
flow information:
Cash payments for:
Interest expense...... $10,257 11,926 5,821 7,208 13,086 12,631
Federal income taxes.. 841 1,886 621 1,640 2,905 2,883
Supplemental disclosure
of noncash investing
activities:
Mortgage loans
transferred to real
estate owned......... -- 82 -- (82) -- --
See accompanying notes to consolidated financial statements.
F-6
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands)
(1) Summary of Significant Accounting Policies
(a) Description of Business
Heritage Financial Corporation (the Company) is a bank holding company
incorporated in the State of Washington in August 1997. The Company was
organized for the purpose of acquiring all of the capital stock of Heritage
Bank upon its reorganization from a mutual holding company form of
organization to a stock holding company form of organization.
The Company is primarily engaged in the business of planning, directing and
coordinating the business activities of its wholly owned subsidiaries:
Heritage Bank, and Central Valley Bank. Heritage Bank is a Washington-
chartered savings bank whose deposits are insured by the Federal Deposit
Insurance Corporation (FDIC) under the Savings Association Insurance Fund
(SAIF). Heritage Bank conducts business from its main office in Olympia,
Washington and its eleven branch offices located in Thurston, Pierce and Mason
Counties. Central Valley Bank is a National Bank whose deposits are insured by
the Federal Deposit Insurance Corporation (FDIC) under the Bank Insurance Fund
(BIF). Central Valley Bank conducts business from its main office in
Toppenish, Washington, and its four branch offices located in Yakima County.
Effective June 12, 1998, the Company acquired North Pacific Bank, a
Washington-chartered commercial bank which was merged into Heritage Bank
effective November 20, 1998.
The Company's business consists primarily of focusing on lending and deposit
relationships with small businesses including agribusiness and their owners in
its 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. The Company also makes residential
construction loans, income property loans and consumer loans.
(b) Basis of Presentation
The accounting and reporting policies of the Company and its subsidiaries
conform to generally accepted accounting principles. In preparing the
consolidated financial statements, management makes estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of financial statements and the
reported amounts of income and expense during the reported periods. Actual
results could differ from these estimates.
The accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries.
Effective March 5, 1999, the company acquired all of the outstanding common
stock of Washington Independent Bancshares, Inc., (whose wholly owned
subsidiary is Central Valley Bank, N.A., Toppenish, Washington) in exchange
for 1,058,009 shares of Heritage common stock. This transaction was accounted
for as a pooling of interest and, accordingly, the Company's financial
information reported herein has been restated to include the accounts and
results of operations of Washington Independent Bancshares, Inc., for all
periods presented. The financial statements shown herein prior to the January
8, 1998 stock conversion exclude the Company and are for Heritage Bank and
Washington Independent Bancshares, Inc. only as the Company did not engage in
any material transactions until after January 8, 1998. All significant
intercompany balances and transactions among the Company and its subsidiaries
have been eliminated in consolidation. Certain amounts in the consolidated
financial statements for prior years have been reclassified to conform to the
current consolidated financial statement presentation.
F-7
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
On October 28, 1998, the Company's Board of Directors voted to change the
Company's fiscal year ending June 30 to a calendar year beginning January 1st
and ending December 31st.
(c) Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents includes
cash on hand and in banks, interest bearing deposits, and fed funds sold.
(d) Investment Securities
Securities are classified as held to maturity when the Company has the
ability and positive intent to hold them to maturity. Securities classified as
available for sale are available for future liquidity requirements and may be
sold prior to maturity.
Investment securities held to maturity are recorded at cost, adjusted for
amortization of premiums or accretion of discounts using the straight line
method. Securities available for sale are carried at fair value. Unrealized
gains and losses on securities available for sale are excluded from earnings
and are reported net of tax as a separate component (Accumulated other
comprehensive income) of stockholders' equity until realized. Realized gains
and losses on sale are computed on the specific identification method.
(e) Loans Receivable and Loans Held for Sale
Loans are generally recorded at cost, net of discounts, unearned fees and
deferred fees. Discounts and premiums on purchased loans are amortized using
the interest method over the remaining contractual life, adjusted for actual
prepayments. Mortgage loans held for sale are carried at the lower of
amortized cost or market value determined on an aggregate basis. Any loan that
management determines will not be held to maturity is classified as held for
sale at the time of origination, purchase or securitization. Unrealized losses
on such loans are included in income.
(f) Loan Fees
Loan origination fees and certain direct origination costs are deferred and
amortized as an adjustment of the yields of the loans over their contractual
lives, adjusted for prepayment of the loans, using the interest method. In the
event loans are sold, the deferred net loan origination fees or costs are
recognized as a component of the gains or losses on the sales of loans.
(g) Allowance for Loan Losses
A valuation allowance for loans is based on management's estimate of the
amount necessary to recognize possible losses inherent in the loan portfolio.
In determining the level to be maintained, management evaluates many factors
including the borrowers' ability to repay, economic and market trends and
conditions, holding costs and absorption periods. In the opinion of
management, the present allowance is adequate to absorb reasonably foreseeable
loan losses at December 31, 1999.
While management uses available information to recognize losses on these
loans, future additions to the allowances may be necessary based on changes in
economic conditions. In addition, various regulatory agencies, as an integral
part of their examination process, periodically review the Bank's allowance
for losses on loans. Such agencies may require the Bank to make additions to
the allowance based on their judgments about information available to them at
the time of their examinations.
F-8
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(h) Impaired Loans
The accrual of interest on loans is discontinued and the loan is considered
impaired when, in the opinion of management, the collectibility of principal
or interest is in doubt or generally when the loans are contractually past due
90 days or more with respect to principal or interest. When accrual of
interest is discontinued on a loan, the interest accrued but not collected is
charged against operations. Thereafter, payments received are generally
applied to principal. However, based on management's assessment of the
ultimate collectibility of an impaired or nonaccrual loan, interest income may
be recognized on a cash basis. Impaired loans and other nonaccrual loans are
returned to an accrual status when management determines that the
circumstances have improved to the extent that there has been a sustained
period of repayment performance and both principal and interest are deemed
collectible.
(i) Mortgage Banking Operations
Heritage Bank sells mortgage loans primarily on a servicing released basis
and recognizes a cash gain or loss. A cash gain or loss is recognized to the
extent that the sales proceeds of the mortgage loans sold exceed or are less
than the net book value at the time of sale.
Loan servicing income is recorded when earned. Loan servicing costs are
charged to expense as incurred.
(j) Real Estate Owned
Real estate acquired by the Bank in satisfaction of debt is recorded at fair
value at time of foreclosure and is carried at the lower of the new cost basis
or fair value. Subsequently, foreclosed assets are carried at the lower of
cost or fair value less estimated costs to sell.
(k) Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization are computed using the straight-
line method over the estimated useful lives of the assets. The estimated
useful lives used to compute depreciation and amortization for buildings and
building improvements, is 30 to 40 years; and for furniture, fixtures and
equipment, 3 to 10 years.
(l) Goodwill
Goodwill represents the costs in excess of net assets acquired arising from
the purchase of North Pacific Bank and is being amortized on a straight line
basis over 15 years. The Company will periodically evaluate goodwill for
impairment.
(m) Federal Income Taxes
Deferred taxes result from the timing differences in the recognition of
certain income and expense amounts between the Company's financial statements
and its tax returns. Deferred tax assets and liabilities are reflected at
currently enacted income tax rates applicable to the period in which the
deferred tax assets or liabilities are expected to be realized or settled. As
tax laws change or rates enacted, deferred tax assets and liabilities are
adjusted through the provision for income taxes.
F-9
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(n) Employee Stock Ownership Plan
Heritage Bank sponsors an Employee Stock Ownership Plan (ESOP). The ESOP
purchased 2% of the common stock issued in the January 1998 stock offering and
borrowed from the Company in order to fund the purchase of the Company's
common stock. The loan to the ESOP will be repaid principally from the Bank's
contributions to the ESOP. The Bank's contributions will be sufficient to
service the debt over the 15 year loan term at the interest rate of 8.5%,
after the effect of cash dividends on unallocated shares. As the debt is
repaid, shares are released and allocated to plan participants based on the
proportion of debt service paid during the year. As shares are released,
compensation expense is recorded equal to the then current market price of the
shares and the shares become outstanding for earnings per share calculations.
Cash dividends on allocated shares are recorded as a reduction of retained
earnings and paid or distributed directly to participants' accounts. Cash
dividends on unallocated shares are recorded as a reduction of debt and
accrued interest.
(o) Recent Financial Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board (FASB) issued SFAS
No. 133, "Accounting for Derivative Instruments and Hedging Activities". This
statement establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts (collectively referred to as derivatives) and for hedging
activities. In May 1999, the FASB delayed the effective date of SFAS No. 133
to fiscal years beginning after June 15, 2000, with interim reporting
required. Management does not expect that application of this statement will
have a material effect on the results of operations or the financial position
of the Corporations.
In October 1998, the FASB issued SFAS No. 134 (which amended SFAS No. 65),
"Accounting for Certain Mortgage Banking Activities." This statement
establishes accounting and reporting standards for securities retained after
the securitization of mortgage loans and was adopted by the Company on January
1, 1999. The adoption of SFAS No. 134 did not have a material impact on its
financial position or results of operations.
F-10
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(2) Business Combinations
a. North Pacific Bank
The Company completed the acquisition of North Pacific Bank effective June
12, 1998. The Company paid the former stockholder of North Pacific
Bancorporation $17.5 million in cash for the common stock of North Pacific
Bancorporation. This acquisition was treated as a purchase for accounting
purposes. Accordingly, under generally accepted accounting principles, the
assets and liabilities of North Pacific Bank have been recorded on the books
of the Company at their respective fair values at the date the acquisition was
consummated. Goodwill, the excess of the purchase price (cost) over the net
fair value of the assets and liabilities acquired, was recorded at $8.6
million. Accumulated amortization of goodwill amounted to $288 and $865 as of
December 31, 1998 and December 31, 1999, respectively. The following are the
fair values of assets acquired and liabilities assumed as of the June 12, 1998
acquisition date:
Cash acquired, net of cash paid for acquisition..................... $10,573
Securities.......................................................... 12,277
Loans, net.......................................................... 48,620
Premises and equipment.............................................. 4,397
Goodwill............................................................ 8,631
Other assets........................................................ 499
-------
Total assets...................................................... $84,997
=======
Deposits............................................................ $82,410
FHLB advances....................................................... 698
Other borrowed funds................................................ 947
Deferred federal income taxes....................................... 499
Other liabilities................................................... 443
-------
Total liabilities................................................. $84,997
=======
The financial statements for the year ended June 30, 1998 include the
operations of North Pacific Bank from June 12, 1998 to June 30, 1998.
Effective November 20, 1998, the operations of North Pacific Bank were merged
with Heritage Bank. The following information presents the actual results of
operations for the year ended June 30, 1998 and the proforma results of
operations for the years ended June 30, 1998, and 1997, as though the
acquisition had occurred on July 1, 1996. The proforma results do not
necessarily indicate the actual result that would have been obtained nor are
they necessarily indicative of the future operations of the combined
companies.
Years Ended June 30,
Unaudited proforma
Actual ---------------------
1998 1997 1998
------- ---------- ----------
(in thousands, except per
share amounts)
Net interest income before provision for
loan loss.................................. $16,110 $ 15,196 $ 19,165
Net income.................................. $ 4,259 2,331 3,721
Earnings per common share:
Basic..................................... $ 0.41 0.23 0.36
Diluted................................... 0.40 0.22 0.35
F-11
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
b. Washington Independent Bancshsares, Inc
On September 28, 1998, the Company entered into a definitive merger
agreement with Washington Independent Bancshares, Inc. (WIB) whereby the
Company would acquire all of the outstanding common stock of WIB (whose wholly
owned subsidiary is Central Valley Bank, NA, Toppenish, Washington). The
transaction closed on March 5, 1999, and the Company exchanged 1,058,009
shares of its common stock for all of the outstanding WIB common stock, and
merged WIB into Heritage Financial Corporation. This transaction was accounted
for as a pooling of interests and accordingly, the Company's historical
consolidated financial statements presented in this and all future reports
will include the accounts and results of operations of WIB, primarily
consisting of its subsidiary, Central Valley Bank. A summary of revenue and
net income previously presented by the Company and combined with WIB for the
years ended June 30, 1997, June 30, 1998, and the six months ended December
31, 1998 are as follows:
Year ended June 30, 1997
------------------------------------
Company WIB Combined
---------------------- -------------
Total revenue............................ $ 21,859 $ 4,349 $ 26,208
Net Income............................... 2,269 329 2,598
Year ended June 30, 1998
------------------------------------
Company WIB Combined
---------------------- -------------
Total revenue............................ $ 26,932 $ 5,306 $ 32,238
Net Income............................... 3,628 631 4,259
Six months ended December 31, 1998
------------------------------------
Company WIB Combined
---------------------- -------------
Total revenue............................ $ 18,085 $ 3,026 $ 21,111
Net Income............................... 1,924 242 2,166
(3) Loans Receivable and Loans Held for Sale
Loans receivable and loans held for sale consist of the following:
December 31,
-----------------
1998 1999
-------- -------
Commercial loans........................................ $128,171 192,088
Real Estate Mortgages:
One to four family residential........................ 97,278 97,907
Five or more family residential and commercial real
estate............................................... 70,139 94,242
-------- -------
Total Real Estate Mortgage............................ 167,417 192,149
Real Estate Construction:
One to four family residential........................ 26,640 23,293
Five or more family residential and commercial real
estate............................................... 2,123 7,537
-------- -------
Total Real Estate Construction.......................... 28,763 30,830
Consumer.............................................. 4,000 4,273
-------- -------
Subtotal.............................................. 328,351 419,340
Unamortized yield adjustments........................... (1,400) (1,578)
-------- -------
Total Loans Receivable and Loans Held for Sale........ $326,951 417,762
======== =======
F-12
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Accrued interest on loans receivable amounted to $2,097 and $2,505 as of
December 31, 1998 and December 31, 1999, respectively. The Company had $401
and $1,804 of impaired loans which were nonaccruing as of December 31, 1998
and December 31, 1999, respectively. The weighted average interest rate on
loans was 8.6% for both December 31, 1998 and December 31, 1999.
Details of certain mortgage banking activities are as follows:
December 31,
---------------
1998 1999
------- -------
Loans held for sale at lower of cost or market................ $ 7,618 $ 589
Loans serviced for others..................................... 18,832 13,086
Commitments to sell mortgage loans............................ 11,533 1,895
Commitments to fund mortgage loans (at interest rates
approximating market rates)
Fixed rate.................................................. 4,704 540
Variable or adjustable rate................................. -- --
Servicing fee income from mortgage loans serviced for others amounted to
$72, $56, $22, and $34 for the years ended June 30, 1997, June 30, 1998, the
six months ended December 31, 1998, and the year ended December 31, 1999,
respectively.
Commitments to sell mortgage loans are made primarily during the period
between the taking of the loan application and the closing of the mortgage
loan. The timing of making these sale commitments is dependent upon the timing
of the borrower's election to lock-in the mortgage interest rate and fees
prior to loan closing. Most of these sale commitments are made on a best-
efforts basis whereby the Bank is only obligated to sell the mortgage if the
mortgage loan is approved and closed by the Bank.
As of December 31, 1999, the Company had commitments of $48.0 million in
other commercial lines of credit, $32.4 million in real estate commitments
(both construction and lines of credit), and $7.5 million in other commitments
(including consumer credit lines and letters of credit).
(4) Allowance for Loan Losses
Activity in the allowance for loan losses is summarized as follows:
Year Ended Six Months Year Ended
June 30, Ended Dec, 31 Dec 31,
------------- ------------- ----------
1997 1998 1998 1999
------ ----- ------------- ----------
Balance at beginning of
period................... $2,221 3,105 3,929 3,957
Provision............... (265) 149 202 408
Recoveries.............. 1,158 8 13 146
Charge offs............. (9) (3) (187) (247)
Acquired with North
Pacific Bank........... -- 670 -- --
------ ----- ----- -----
Balance at end of period.. $3,105 3,929 3,957 4,264
====== ===== ===== =====
In May 1996, the Bank sold its interest in two loans which were partially
charged off. This sale resulted in an excess of net proceeds over the book
basis of these loans of $1.3 million. The Bank recorded a recovery of $148 in
1996 which was the pro rata portion of the sale proceeds received in cash
versus the amount the Bank financed for the purchaser. The additional $1,152
was recognized as a recovery in 1997 when the Bank received additional
collateral on this financing.
F-13
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Interest on nonaccrual loans foregone was $11 and $60 for the six months
ended December 31, 1998 and the year ended December 31, 1999. Foregone
interest was immaterial for prior periods.
(5) Investment Securities Available For Sale
The amortized cost and fair values of investment securities available for
sale at the dates indicated are as follows:
Gross Gross
Amortized unrealized unrealized Fair
cost gains losses value
--------- ---------- ---------- ------
December 31, 1998
U.S. Government and its agencies.... $ 26,597 72 (96) 26,573
Mortgage backed and related
securities:
Collateralized mortgage
obligations...................... 2,812 -- (10) 2,802
Other............................. 1,099 215 -- 1,314
Corporate notes..................... 1,001 9 -- 1,010
-------- --- ---- ------
$ 31,509 296 (106) 31,699
======== === ==== ======
December 31, 1999
U.S. Government and its agencies.... $ 33,192 -- (669) 32,523
Mortgage backed and related
securities:
Collateralized mortgage
obligations...................... 1,611 -- (28) 1,583
Other............................. 1,100 184 (8) 1,276
Corporate notes..................... 1,000 1 (5) 996
-------- --- ---- ------
Totals.......................... $ 36,903 185 (710) 36,378
======== === ==== ======
The amortized cost and fair value of securities available for sale, by
contractual maturity, at December 31, 1999 are shown below:
Amortized Fair
cost value
--------- ------
Due in one year or less.................................. $ 2,500 2,488
Due after one year through three years................... 26,101 25,590
Due after three through five years....................... 5,091 4,946
Due after five years through ten years................... 796 784
Due after ten years...................................... 2,415 2,570
------- ------
Totals................................................... $36,903 36,378
======= ======
There were no sales of investment securities available for sale during the
years ended June 30, 1997, 1998, the six months ended December 31, 1998 or the
year ended December 31, 1999.
Accrued interest on investment securities available for sale amounted to
$253 and $385 as of December 31, 1998 and December 31, 1999, respectively.
At December 31, 1998 and December 31, 1999, investment securities available
for sale with fair values of $2,810 and $14,608 were pledged to secure public
deposits and for other purposes as required or permitted by law.
F-14
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(6) Investment Securities Held to Maturity
The amortized cost and fair values of investment securities held to maturity
are as follows:
Gross Gross
Amortized unrealized unrealized Fair
cost gains losses value
--------- ---------- ---------- ------
December 31, 1998
U.S. Government and its agencies..... $ 9,846 26 (3) 9,869
Mortgage backed securities:
FNMA certificates.................. 734 10 -- 744
FHLMC certificates................. 851 22 -- 873
GNMA certificates.................. 1,677 54 -- 1,731
Municipal bonds...................... 2,789 77 (2) 2,864
-------- --- --- ------
$ 15,897 189 (5) 16,081
======== === === ======
December 31, 1999
U.S. Government and its agencies..... $ 1,200 -- (6) 1,194
Mortgage backed securities:
FNMA certificates.................. 433 15 (1) 447
FHLMC certificates................. 544 15 -- 559
GNMA certificates.................. 1,422 65 -- 1,487
Municipal bonds...................... 2,566 4 (38) 2,532
-------- --- --- ------
$ 6,165 99 (45) 6,219
======== === === ======
The amortized cost and fair value of investment securities held to maturity,
by contractual maturity, at December 31, 1999 are shown below:
Amortized Fair
cost value
--------- -----
Due in one year or less................................... $ 813 819
Due after one year through three years.................... 1,616 1,605
Due after three years through five years.................. 750 741
Due after five years through ten years.................... 1,003 991
Due after ten years....................................... 1,983 2,063
------ -----
Totals.................................................... $6,165 6,219
====== =====
There were no sales of investment securities held to maturity during the
years ended June 30, 1997, June 30, 1998, or for the years ended December 31,
1998, or December 31, 1999.
Accrued interest on investment securities held to maturity amounted to $230
and $33 as of December 31, 1998 and December 31, 1999, respectively.
At December 31, 1998 and December 31, 1999, investment securities held to
maturity with amortized cost values of $3,899 and $700 were pledged to secure
public deposits and for other purposes as required or permitted by law.
F-15
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(7) Premises and Equipment
A summary of premises and equipment follows:
December 31,
---------------
1998 1999
-------- ------
Land...................................................... $ 4,196 4,518
Buildings and building improvements....................... 14,181 15,034
Furniture, fixtures and equipment......................... 10,116 11,204
-------- ------
28,493 30,756
Less accumulated depreciation............................. 10,371 11,882
-------- ------
$ 18,122 18,874
======== ======
(8) Deposits
Deposits consist of the following:
December 31,
----------------------------------
1998 1999
----------------- ----------------
Amount Percent Amount Percent
--------- ------- -------- -------
Non interest demand deposits........... $ 38,675 10.5% $ 42,639 10.5%
NOW accounts........................... 46,245 12.6 51,686 12.8
Money market accounts.................. 42,474 11.6 44,239 10.9
Savings accounts....................... 66,852 18.2 66,107 16.3
Certificate accounts................... 172,752 47.1 200,397 49.5
--------- ----- -------- -----
$366,998 100.0% $405,068 100.0%
========= ===== ======== =====
The combined weighted average interest rate of deposits was 3.62% and 3.67%
at December 31, 1998 and December 31, 1999, respectively. Accrued interest
payable on deposits was $246 and $618 at December 31, 1998 and December 31,
1999, respectively. Interest expense, by category, is as follows:
Year Ended Six Months Ended Year Ended
June 30, December 31, December 31,
-------------- ----------------- ------------------
1997 1998 1997 1998 1998 1999
------- ------ ----------- ----- ---------- ------
(unaudited) (unaudited)
NOW accounts ........... $ 590 666 325 435 776 767
Money market accounts... 1,860 2,077 1,035 1,367 2,409 2,872
Savings accounts........ 469 511 244 476 743 1,098
Certificate accounts.... 7,437 8,556 4,196 4,861 9,221 8,271
------- ------ ----- ----- ------ ------
$10,356 11,810 5,800 7,139 13,149 13,008
======= ====== ===== ===== ====== ======
Scheduled maturities of certificate accounts at December 31, 1999 are as
follows:
Within one year.................................... $175,806
Between one and two years.......................... 22,067
Between two and three years........................ 704
Between three and four years....................... 1,275
Between four and five years........................ 545
--------
$200,397
========
F-16
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Certificates of deposit issued in denominations equal to or in excess of
$100,000 totaled $30,759 and $76,958 at December 31, 1998 and December 31,
1999.
(9) FHLB Advances and Stock
The Bank is required to maintain an investment in the stock of the Federal
Home Loan Bank of Seattle (FHLB) in an amount equal to at least 1% of the
unpaid principal balances of the Bank's residential mortgage loans or 5% of
its outstanding advances from the FHLB, whichever is greater. At December 31,
1999, the Bank was required to maintain an investment in the stock of FHLB of
Seattle of at least $0.8 million. Purchases and sales of stock are made
directly with the FHLB at par value.
A summary of FHLB Advances follows:
December
31,
------------
1999 1999
---- ------
Balance at period end...................................... $687 $2,800
Average balance............................................ 693 958
Maximum amount outstanding at any month end................ 696 3,300
Average interest rate:
During the period........................................ 6.20% 5.90%
At period end............................................ 6.20% 5.70%
At December 31, 1999 Heritage Bank had an overnight advance of $2,800 at
5.70% from the FHLB.
Advances from the FHLB are collateralized by a blanket pledge on FHLB stock
owned by the Company, deposits at the FHLB and all mortgages or deeds of trust
securing such properties. In accordance with the pledge agreement, the Company
must maintain unencumbered collateral in an amount equal to varying
percentages ranging from 100% to 125% of outstanding advances depending on the
type of collateral.
The Bank may borrow from the FHLB in amounts up to 20% of its total assets.
(10) Repurchase Agreements
The maximum and average outstanding balances and average interest rates on
repurchase agreements were as follows:
Six Months
Ended Year Ended
December 31, December 31,
1998 1999
------------ ------------
Maximum outstanding at any month-end............... $483 $--
Average outstanding................................ 320 --
Weighted average interest rate: --
For the period................................... 3.25%
End of period.................................... -- --
F-17
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(11) Federal Income Taxes
Federal income tax expense (benefit) consists of the following:
Six Months
Year Ended Ended Year Ended
June 30, December 31, December 31,
------------ ------------ ------------
1997 1998 1998 1999
----- ----- ------------ ------------
Current.............................. $ 527 2,276 1,419 3,011
Deferred............................. (515) (3) (144) (53)
----- ----- ----- -----
$ 12 2,273 1,275 2,958
===== ===== ===== =====
Federal income tax expense differs from that computed by applying the
Federal statutory income tax rate of 34% as follows:
Six Months
Year Ended Ended Year Ended
June 30, December 31, December 31,
------------ ------------ ------------
1997 1998 1998 1999
----- ----- ------------ ------------
Income tax expense at Federal
statutory rate..................... $ 887 2,221 1,170 2,827
Goodwill amortization tax effect.... -- -- 98 199
Reversal of provision for base year
bad debt reserve................... (938) -- -- --
Other, net.......................... 63 52 7 (68)
----- ----- ----- -----
$ 12 2,273 1,275 2,958
===== ===== ===== =====
Heritage Bank has been permitted under the Internal Revenue Code to deduct
an annual addition to a reserve for bad debts in determining taxable income,
subject to certain limitations. The deduction was based on either specified
experience formulas or a percentage of taxable income before such deduction.
Heritage Bank used the percentage of taxable income method for the years ended
June 30, 1995 and 1996. This deduction was historically greater than the loan
loss provisions recorded for financial accounting purposes. Deferred income
taxes are provided on differences between the bad debt reserve for tax and
financial reporting purposes only to the extent of the tax reserves arising
subsequent to June 30, 1988. Savings institutions were not required to provide
a deferred tax liability for the tax bad debt reserves accumulated as of June
30, 1988 which for Heritage Bank amounted to $938. Starting in the fiscal year
ended June 30, 1994, The Bank established and maintained a deferred income tax
liability of $938 due to the potential recapture of the pre-1988 tax bad debt
reserve which could have been triggered by the formation of the mutual holding
company; a change to a commercial bank charter (which management had been
contemplating); or possible legislation which was being debated in Congress.
Legislation enacted in August 1996 eliminated certain conditions under which
recapture of the pre-1988 additions to the tax bad debt reserve would be
required. Such conditions are principally conversion to a commercial bank
charter or merger with a commercial bank. The pre-1988 reserves would be
required to be recaptured under certain other conditions such as payment of
dividends in excess of accumulated earnings and profits or other distributions
made in connection with the dissolution or liquidation of the Bank. Based on
this legislation, Heritage Bank reversed the $938 deferred tax liability as a
reduction of Federal income tax expense during the year ended June 30, 1997.
F-18
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The following table presents major components of the deferred Federal income
tax liability resulting from differences between financial reporting and tax
bases.
December 31,
---------------
1998 1999
------- ------
Deferred tax liabilities:
Deferred loan fees........................................ $ 363 671
Deferred income........................................... 129 --
Premises and equipment.................................... 1,283 1,041
FHLB stock................................................ 425 478
Unrealized gains on securities available for sale......... 62 --
------- ------
Total deferred tax liabilities.......................... 2,262 2,190
======= ======
Deferred tax assets:
Loan loss allowances...................................... (713) (821)
Management bonus.......................................... (223) (153)
Vacation benefits......................................... (108) (94)
Unrealized losses on securities available for sale........ -- (178)
Other..................................................... (66) (85)
------- ------
Total deferred tax assets............................... (1,110) (1,331)
------- ------
Deferred taxes payable, net............................. $ 1,152 859
======= ======
The realization of the Company's deferred tax assets is dependent upon the
Company's ability to generate taxable income in future periods. Management has
evaluated available evidence supporting the realization of its deferred tax
assets and determined it is more likely than not that deferred tax assets will
be realized.
(12) Stockholders' Equity
(a) Stock Offering and Conversion
Effective January 8, 1998, the Company sold 6.6 million shares of its common
stock at a subscription price of $10 per share to the Bank's customers, its
existing stockholders and the general public.
Of the 1.8 million shares of Heritage Savings Bank common stock outstanding
at December 31, 1997, 1.2 million shares owned by Heritage Financial
Corporation, M.H.C. (the "Mutual Holding Company") were canceled on January 8,
1998 and the Mutual Holding Company was merged into the Bank. The remaining
0.6 million shares of the Bank's common stock owned by its stockholders were
converted into 3.1 million shares of the Company's common stock outstanding.
Concurrent with the January 1998 stock conversion ("Conversion"), Heritage
Savings Bank established a liquidation account equal to $18.4 million which
represents the Mutual Holding Company's ownership interest in its Bank
subsidiary at June 30, 1997 plus the amount of dividends waived by the Mutual
Holding Company. The liquidation account is maintained for the benefit of
eligible depositors who maintain eligible accounts in the Bank after the
conversion. In the event of a complete liquidation of the Bank (and only in
such an event), eligible depositors who continue to maintain eligible accounts
shall be entitled to receive a distribution from the liquidation account
before any liquidating distribution may be made with respect to common stock.
F-19
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
On April 26, 1999 board of directors of the Company authorized the
repurchase in the open market of 100,000 of our shares. This was accomplished
in the second quarter for $0.8 million, or $8.56 per share. On October 22,
1999 the Company announced its intention to repurchase up to 10% of its
outstanding common shares, or approximately 1.1 million shares. During the
fourth quarter of 1999, the Company repurchased 821,050 shares, representing
7.5% of the 10.0% of stock intended to be repurchased for $7.0 million at an
average price of $8.55 per share. On February 18, 2000, the Company announced
the repurchase of an additional 10%, or approximately 975,000 shares. The
additional share repurchase will take place over the next 18 months.
(b) Earnings Per Common Share
The following table illustrates the reconciliation of weighted average
shares used for earnings per share computations:
Year Ended Six Months Ended Year Ended
June 30, December 31, December 31,
--------------------- ---------------------- ----------------------
1997 1998 1997 1998 1998 1999
---------- ---------- ---------- ---------- ---------- ----------
(unaudited) (unaudited)
Basic:
Weighted average
shares .............. 10,226,392 10,394,415 10,235,550 10,553,279 10,663,238 10,763,066
Diluted:
Basic weighted average
shares outstanding... 10,226,392 10,394,415 10,235,550 10,553,279 10,663,238 10,763,066
Incremental shares
from stock options... 516,415 275,291 18,337 476,318 396,677 172,331
---------- ---------- ---------- ---------- ---------- ----------
Weighted average
shares outstanding... 10,742,807 10,669,706 10,253,887 11,029,597 11,059,915 10,935,397
========== ========== ========== ========== ========== ==========
For purposes of calculating basic and diluted EPS, the numerator of net
income is the same.
Earnings per share information for periods prior to January 8, 1998 is based
on the historical weighted average common shares outstanding for the Bank
during the applicable period multiplied by the exchange ratio utilized in the
stock conversion (5.1492). On January 8, 1998, the former stockholders of the
Bank received 5.1492 shares of the Company's common stock for each share of
the Bank's common stock exchanged.
There were 92,700 shares and 96,150 shares of common stock outstanding at
December 31, 1998 and December 31, 1999 whose share price were greater than
the market price of the common stock and therefore not included in the
computation of diluted earnings per share. There were no antidilutive
outstanding options to purchase common stock at June 30, 1998, and June 30,
1997.
(c) Cash Dividend Declared
On December 16, 1999, the Company announced a quarterly cash dividend of 7
cents per share payable on January 27, 2000, to shareholders of record on
January 14, 2000.
(d) Restrictions on Dividends
Dividends from the Company depend, in part, upon receipt of dividends from
its subsidiary banks because the Company currently has no source of income
other than dividends from Heritage Bank, Central Valley Bank, and earnings
from the investment of the net proceeds from the Conversion retained by the
Company.
F-20
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The FDIC and the Washington State Department of Financial Institutions
("DFI") have the authority under their supervisory powers to prohibit the
payment of dividends by the Heritage Bank to the Company. For a period of ten
years after the Conversion, Heritage Bank may not, without prior approval of
the DFI, declare or pay a cash dividend in an amount in excess of one-half of
(i) the greater of the Bank's net income for the current fiscal year or (ii)
the average of the Bank's net income for the current fiscal year and not more
than two of the immediately preceding fiscal years. In addition, the banks may
not declare or pay a cash dividend on its common stock if the effect thereof
would be to reduce the net worth of the Bank below the amount required for the
liquidation account. Other than the specific restrictions mentioned above,
current regulations allow the Company and its subsidiary banks to pay
dividends on their common stock if the Company's or Bank's regulatory capital
would not be reduced below the statutory capital requirements set by the
Federal Reserve and the FDIC.
For Central Valley Bank the approval of the Comptroller of the Currency
shall be required if the total of all dividends declared by Central Valley
Bank in any calendar year exceeds the total of its net income of that year
combined with its retained net income of the preceding two years, less any
required transfers to surplus or a fund for the retirement of any preferred
stock.
(13) Regulatory Capital Requirements
The Company is a bank holding company under the supervision of the Federal
Reserve Bank. Bank holding companies are subject to capital adequacy
requirements of the Federal Reserve under the Bank Holding Company Act of
1956, as amended, and the regulations of the Federal Reserve. Heritage Bank
and Central Valley Bank are federally insured institutions and thereby subject
to the capital requirements established by the Federal Deposit Insurance
Corporation (FDIC). The Federal Reserve requirements generally parallel the
FDIC requirements. Failure to meet minimum capital requirements can initiate
certain mandatory, and possibly additional discretionary, actions by
regulators that, if undertaken, could have a direct material effect on the
Company's financial statements.
Pursuant to minimum capital requirements of the FDIC, the Bank is required
to maintain a leverage ratio (capital to assets ratio) of 3% and risk-based
capital ratios of Tier 1 capital and total capital (to total risk-weighted
assets) of 4% and 8%, respectively. At December 31, 1998, and 1999, the
Company exceeded the minimum capital requirements and the requirements for
well capitalized institutions as shown below. As of December 31, 1998 and
December 31, 1999, Heritage Bank and Central Valley Bank were both classified
as "well capitalized" institutions under the criteria established by the FDIC
Act. There are no conditions or events since that notification that management
believes have changed the Bank's classification as a well capitalized
institution.
F-21
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Minimum Well-capitalized
Requirements Requirements Actual
----------------------------------------------
$ % $ % $ %
-------- ---------------- --------------- ----
As of December 31, 1999:
The Company consolidated
Tier 1 leverage capital to
average assets............... $ 13,908 3% $ 23,181 5% $87,340 18.9%
Tier 1 capital to risk-
weighted assets.............. 16,573 4 24,859 6 87,340 21.1
Total capital to risk-weighted
assets....................... 33,145 8 41,432 10 91,603 22.1
Heritage Bank
Tier leverage capital to
average assets............... 12,438 3 20,729 5 77,650 18.7
Tier 1 capital to risk-
weighted assets.............. 14,518 4 21,776 6 77,650 21.4
Total capital to risk-weighted
assets....................... 29,035 8 36,294 10 81,466 22.5
Central Valley Bank
Tier leverage capital to
average assets............... 1,930 3 3,216 5 5,358 8.3
Tier 1 capital to risk-
weighted assets.............. 2,047 4 3,070 6 5,358 10.5
Total capital to risk-
weighted assets.............. 4,094 8 5,117 10 5,805 11.3
Minimum Well-capitalized
Requirements Requirements Actual
----------------------------------------------
$ % $ % $ %
-------- ---------------- --------------- ----
As of December 31, 1998:
The Company consolidated
Tier 1 leverage capital to
average assets............... $ 12,819 3% $ 21,364 5% $91,787 21.4%
Tier 1 capital to risk-
weighted assets.............. 13,131 4 19,697 6 91,787 27.8
Total capital to risk-weighted
assets....................... 26,263 8 32,829 10 95,744 29.0
Heritage Bank
Tier 1 leverage capital to
average assets............... 10,305 3 17,176 5 74,652 21.7
Tier 1 capital to risk-
weighted assets.............. 11,337 4 17,006 6 74,652 26.3
Total capital to risk-weighted
assets....................... 22,674 8 28,343 10 78,195 27.6
Central Valley Bank
Tier 1 leverage capital to
average assets............... 1,865 3 3,109 5 4,731 7.6
Tier 1 capital to risk-
weighted assets.............. 1,695 4 2,543 6 4,731 10.7
Total capital to risk-weighted
assets....................... 3,391 8 4,239 10 5,138 11.6
(14) Stock Option Plans
In September 1994, the 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, the 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.
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 Bank's or
Company's common stock. The 1994 plan provides for the grant of
F-22
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
options and stock awards up to 67,000 shares. The 1997 plan provides for the
granting of options and stock awards for up to 50,000 common shares. The above
117,000 shares approved under the 1994 and 1997 plans for the grant of options
and stock awards were converted to 602,456 shares at January 8, 1998 using the
exchange ratio of one share of the Bank's common stock for 5.1492 shares of
the Company's common stock. The 1998 plan provides for the grant of stock
options and stock awards for up to 461,125 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.
The following table summarizes stock option activity for the years ended
June 30, 1997, 1998, the six months ended December 31, 1998, and year ended
December 31, 1999. Option activity for the periods prior to the stock offering
January 8, 1998 has been restated using the exchange ratio of one share of the
Bank's common stock for 5.1492 shares of the Company's common stock.
Outstanding Exercisable
Options Options
---------------- ----------------
Avg. Avg.
Option Option
Shares Under Option Shares Price Shares Price
------------------- -------- ------ -------- ------
Balance at June 30, 1996..................... 407,931 $ 2.24 247,245 $2.09
Options granted.............................. 314,872 3.61 -- --
Became exercisable........................... -- -- 113,780 2.32
Less: Exercised.............................. (20,340) 1.94 (20,340) 1.94
Expired or canceled........................ (3,560) 4.47 -- --
-------- ------ -------- -----
Balance at June 30, 1997..................... 698,902 2.85 340,685 2.17
======== ====== ======== =====
Options granted.............................. 17,901 10.21 -- --
Became exercisable........................... -- -- 150,082 3.40
Less: Exercised.............................. (61,148) 2.31 (61,148) 2.37
Expired or canceled........................ (15,908) 3.73 (4,751) 3.36
-------- ------ -------- -----
Balance at June 30, 1998..................... 639,747 3.09 424,868 2.57
======== ====== ======== =====
Options granted.............................. 88,800 11.13 -- --
Became exercisable........................... -- -- 8,802 4.87
Less: Exercised.............................. (239,406) 2.29 (239,406) 2.29
Expired or canceled........................ (9,000) 14.38 -- --
-------- ------ -------- -----
Balance at December 31, 1998................. 480,141 4.76 194,264 3.01
======== ====== ======== =====
Options granted.............................. 145,500 8.52 -- --
Became exercisable........................... -- -- 131,649 5.35
Less: Exercised.............................. (91,636) 2.75 (91,636) 2.80
Expired or canceled........................ (32,148) 7.37 (24,818) 5.86
-------- ------ -------- -----
Balance at December 31, 1999................. 501,857 $ 6.06 209,459 $4.24
======== ====== ======== =====
Under the 1997 plan, a restricted stock award of 3,000 shares with a fair
value of $43 was awarded to a key officer and required five years of
continuous employment from the date of award. These shares were issued during
June 1998. However, the officer left the Company's employment in December
1998, and therefore, the restricted stock award was rescinded.
F-23
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Financial data pertaining to outstanding stock options at December 31, 1999
were as follows:
Weighted Average
Remaining Contractual
Exercise Price Number of Option Shares Life (in years)
-------------- ----------------------- ---------------------
$1.94....................... 20,662 1.6
$3.11....................... 36,045 3.0
$3.58....................... 223,900 4.6
$8.50....................... 9,000 6.8
$11.13...................... 76,200 6.4
$9.00....................... 19,950 6.7
$8.75....................... 6,900 6.7
$8.13....................... 2,100 6.7
$8.56....................... 1,500 6.8
$8.50....................... 3,900 6.8
$8.25....................... 9,000 6.9
$8.44....................... 92,700 7.4
------- ---
501,857 5.4
======= ===
The Company has adopted the disclosure-only provisions of SFAS No. 123,
Accounting for Stock-based Compensation, but applies APB Opinion No. 25 and
related interpretations in accounting for its plans. Accordingly, no
compensation cost has been recognized for its stock option plans. If the
Company had elected to recognize compensation cost on the fair value at the
grant dates for awards under its plans, consistent with the method prescribed
by SFAS No. 123, net income and earnings per share would have been changed to
the pro forma amounts indicated below:
Six Months
Year Ended Ended Year Ended
June 30 December 31, December 31,
------------- ------------ ------------
1997 1998 1998 1999
------ ------ ------------ ------------
Net income:
As reported....................... $2,598 $4,259 $2,166 $5,357
Pro forma......................... 2,567 4,194 2,123 5,176
Earnings per common share:
Basic:
As reported....................... 0.25 0.41 0.20 0.50
Pro forma......................... 0.25 0.40 0.20 0.48
Diluted:
As reported....................... 0.24 0.40 0.20 0.49
Pro forma......................... 0.23 0.39 0.19 0.47
The compensation expense included in the pro forma net income is not likely
to be representative of the effect on reported net income for future years
because options vest over several years and additional awards generally are
made each year.
The fair value of options granted is estimated on the date of grant using
the minimum value method for grants in 1996 and 1997. The fair value of
options granted during the year ended June 30, 1998, six months ended December
31, 1998, and year ended December 31, 1999 is estimated on the date of grant
using the Black-
F-24
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Scholes options pricing model. The following assumptions were used to
calculate the fair value of the options granted:
Expected Weighted
Risk Free Expected Life Expected Dividend Average
Grant period ended Interest Rate (in years) Volatility Yield Fair Value
------------------ ------------- ------------- ---------- -------- ----------
June 30, 1996........... 6.50% 7 NA 3% $3.09
June 30, 1997........... 6.50 7 NA 3 3.19
June 30, 1998........... 6.00 7 25% 1.3 5.35
December 31, 1998....... 6.00 7 25 2.1 4.82
December 31, 1999....... 6.50 7 37 3.6 2.76
(15) Employee Benefit Plans
Effective October 1, 1999 the Company combined the three retirement plans, a
money purchase pension plan, a 401k plan, and an employee stock ownership plan
(ESOP) at Heritage Bank, and the 401k plan at Central Valley Bank into one
plan (KSOP).
The pension portion of the KSOP is a defined contribution retirement plan.
The plan allows participation to all employees upon completion of one year of
service and the attainment of 21 years of age. It is the Company's policy to
fund plan costs as accrued. Employee vesting occurs over a period of seven
years, at which time they become fully vested. Charges of approximately $246,
$240, $202, and $252 are included in the consolidated statements of income for
the years ended June 30, 1997, 1998, the six months ended December 31, 1998,
and the year ended December 31, 1999, respectively. Prior to October 1, 1999,
Central Valley Bank did not participate.
The KSOP also maintains the Company's salary savings 401(k) plan for its
employees. All persons employed as of July 1, 1984 automatically participate
in the plan. All employees hired after that date who are at least 21 years of
age and with one year of service to the Company may participate in the plan.
Employees who participate may contribute a portion of their salary which is
matched by the employer at 50% up to certain specified limits. Employee
vesting in employer portions is similar to the retirement plan described
above. Employer contributions for the years ended June 30, 1997, 1998, the six
months ended December 31, 1998, and the year ended December 31, 1999 were
$109, $130, $98, and $148, respectively.
The third portion of the KSOP is the employee stock ownership plan (ESOP).
Heritage Bank established for eligible employees the ESOP and related trust
effective July 1, 1994 which became active upon the former mutual holding
company's conversion to a stock-based holding company in January 1995.
Eligible participants include eligible employees of the Company who are at
least 21 years of age and with one year of service. The ESOP is funded by
employer contributions in cash or common stock. Employee vesting occurs over a
period of seven years. Central Valley Bank employees became eligible to
participate in this plan effective October 1, 1999. Heritage Bank contributed
$75 to the ESOP for the year ended June 30, 1997. Prior to the January 8, 1998
stock offering, the ESOP owned the common stock of Heritage Bank with no
related debt.
In January 1998, the ESOP borrowed $1,323 from the Company to purchase
additional common stock of the Company. The loan will be repaid principally
from the subsidiary bank's contributions to the ESOP over a period of fifteen
years. The interest rate on the loan is 8.5% per annum. ESOP compensation
expense was $88, $95, $65, and $126 for the years ended June 30, 1997, 1998,
the six months ended December 31, 1998, and the year ended December 31, 1999,
respectively.
F-25
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
For the year ended December 31, 1999, the Company has allocated or committed
to be released to the ESOP 8,817 earned shares and has 115,352 unearned,
restricted shares remaining to be released. The fair value of unearned,
restricted shares held by the ESOP trust was $995 at December 31, 1999.
(16) Fair Value of Financial Instruments
Because broadly traded markets do not exist for most of the Company's
financial instruments, the fair value calculations attempt to incorporate the
effect of current market conditions at a specific time. Fair valuations are
management's estimates of values. These determinations are subjective in
nature, involve uncertainties and matters of significant judgment and do not
include tax ramifications; therefore, the results cannot be determined with
precision, substantiated by comparison to independent markets and may not be
realized in an actual sale or immediate settlement of the instruments. There
may be inherent weaknesses in any calculation technique, and changes in the
underlying assumptions used, including discount rates and estimates of future
cash flows, could significantly affect the results. For all of these reasons,
the aggregation of the fair value calculations presented herein do not
represent, and should not be construed to represent, the underlying value of
the Company.
(a) Financial Instruments With Book Value Equal to Fair Value
The fair value of financial instruments that are short-term or reprice
frequently and that have little or no risk are considered to have a fair value
equal to book value.
(b) Investment Securities
The fair value of all investment securities excluding Federal Home Loan Bank
(FHLB) stock was based upon quoted market prices. FHLB stock is not publicly
traded, however it may be redeemed on a dollar-for-dollar basis, for any
amount the Bank is not required to hold. The fair value is therefore equal to
the book value.
(c) Loans
For most loans, fair value is estimated using market prices for mortgage
backed securities or other securities which mirror the attributes of the loans
with similar rates and average maturities adjusted for servicing costs.
Commercial loans and construction loans which are variable rate and short-term
are reflected with fair values equal to book value.
(d) Deposits
For deposits with no contractual maturity, the fair value is equal to the
book value. The fair value of fixed maturity deposits is based on discounted
cash flows using the difference between the deposit rate and an alternative
cost of funds rate.
(e) FHLB Advances
The fair value of FHLB advances are estimated based on discounting the
future cash flows using the rate currently offered on similar borrowings with
similar maturities.
(f) Other Borrowings
Other borrowings consist of a note payable at no stated interest rate. The
fair value is based on discounting the estimated future cash flows using the
rate currently offered on similar borrowings with similar remaining
maturities.
(g) Off-Balance Sheet Financial Instruments
The fair value of off-balance sheet commitments to extend credit is
considered equal to its notional amount.
F-26
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The table below presents the book value amount of the Bank's financial
instruments and their corresponding fair values:
December 31, 1998 December 31, 1999
----------------- -----------------
Book Fair Book Fair
value value value value
-------- -------- -------- --------
Financial Assets
----------------
Cash on hand and in banks.............. $ 13,793 $ 13,793 $ 17,596 $ 17,596
Interest bearing deposits.............. 36,355 36,355 949 949
Federal funds sold..................... 20,800 20,800 2,100 2,100
Investment securities available for
sale.................................. 31,699 31,699 36,378 36,378
Investment securities held to
maturity.............................. 15,897 16,081 6,165 6,219
FHLB stock............................. 2,062 2,062 2,218 2,218
Loans.................................. 322,994 327,977 413,498 413,049
Financial Liabilities
---------------------
Deposits:
Savings, money market and demand..... 194,246 194,246 204,671 204,671
Time certificates.................... 172,752 173,090 200,397 199,719
-------- -------- -------- --------
Total deposits..................... $366,998 367,336 405,068 404,390
======== ======== ======== ========
FHLB advances.......................... $ 687 719 2,800 2,800
Other borrowed funds................... $ 17 16 8 8
(17) Contingencies
The Company is involved in numerous business transactions which, in some
cases, depend on regulatory determination as to compliance with rules and
regulations. Also, the Company has certain litigation and negotiations in
progress. All such matters are attributable to activities arising from normal
operations. In the opinion of management, after review with legal counsel, the
eventual outcome of the aforementioned matters is unlikely to have a
materially adverse effect on the Company's consolidated financial statements
or its financial position.
(18) Heritage Financial Corporation (Parent Company Only)
Heritage Financial Corporation (HFC) was established in connection with the
January 1998 stock conversion and stock offering. HFC's first operating period
was from January 8, 1998 to June 30, 1998 and therefore no financial
information is presented prior to that date.
F-27
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Financial Condition
December 31,
-----------------
1998 1999
--------- -------
ASSETS
------
Interest earning deposits.................................... $ 11,377 $ 3,405
Loans receivable--ESOP....................................... 1,281 1,232
Investment in subsidiary banks............................... 87,988 91,413
Other assets................................................. 710 470
--------- -------
$ 101,356 $96,520
========= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities.................................................. 797 1,256
Total stockholders' equity................................... 100,559 95,264
--------- -------
$ 101,356 $96,520
========= =======
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Income
Six Months
Period Ended Ended Year Ended
June 30, December 31, December 31,
------------ ------------ ------------
1998 1998 1999
------------ ------------ ------------
Interest income:
Interest bearing deposits............. $ 737 $ 309 $ 421
ESOP loan............................. 54 55 106
Other income:
Other income.......................... 15
Equity in undistributed income of
subsidiaries......................... 3,980 2,480 5,462
------ ------ ------
Total income........................ $4,771 $2,844 $6,004
Interest expense........................ 44 7 12
Other expenses.......................... 300 779 667
------ ------ ------
Total expense....................... 344 786 679
====== ====== ======
Income before federal income taxes.. 4,427 2,058 5,325
Provision for income taxes.............. 168 (108) (32)
------ ------ ------
Net income............................ $4,259 2,166 5,357
====== ====== ======
Basic earnings per common share......... $ 0.41 0.20 0.50
Diluted earnings per common share....... $ 0.40 0.20 0.49
F-28
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Cash Flows
Six Months
Period Ended Ended Year Ended
June 30, December 31, December 31,
------------ ------------ ------------
1998 1998 1999
------------ ------------ ------------
Cash flows from operating activities:
Net income............................ $ 4,259 2,166 5,357
Adjustments to reconcile net income to
net cash provided by (used in)
operating activities:
Undistributed income of
subsidiaries....................... (3,980) (2,480) (5,462)
Recognition of compensation related
to ESOP............................ -- 57 75
Other............................... 12 7 97
Net change in accrued interest
receivable, prepaid expenses and
other assets, and accrued expenses
and other liabilities.............. (1,097) 129 1,488
-------- ------ ------
Net cash provided by (used in)
operations....................... (806) (121) 1,555
Cash flows from investing activities:
ESOP loan net of principal
repayments........................... (1,304) 23 49
Sales (Purchase) of Premises &
Equipment............................ (203) (401) (16)
Purchase of North Pacific Bank........ (17,608)
-------- ------ ------
Net cash provided by (used in)
investing activities............. (19,115) (378) 33
-------- ------ ------
Cash flows from financing activities:
Net (increase) decrease in borrowed
funds................................ (24) (202) 19
Cash dividends paid................... (351) (831) (2,438)
Exercise of stock options............. 141 726 271
Proceeds from Stock Sale (Stock
repurchase).......................... 32,435 (7,439)
-------- ------ ------
Net cash provided by financing
activities....................... 32,201 (307) (9,587)
-------- ------ ------
Net increase (decrease) in cash
and cash equivalents............. 12,280 (806) (7,999)
Cash and cash equivalents at beginning
of period.............................. 6 12,286 11,480
-------- ------ ------
Cash and cash equivalents at end of
period................................. $ 12,286 11,480 3,481
======== ====== ======
F-29
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(19) Selected Quarterly Financial Data (Unaudited)
Results of operations on a quarterly basis were as follows (dollars in
thousands, except for per share amounts):
Year Ended December 31, 1999
-------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
Interest income................................ $8,708 8,718 9,260 9,837
Interest expense............................... 3,249 3,006 3,205 3,606
------ ----- ----- -----
Net interest income.......................... 5,459 5,712 6,055 6,231
Provision for loan losses...................... 102 102 102 102
------ ----- ----- -----
Net interest income after provision for loan
losses...................................... 5,357 5,610 5,953 6,129
Non-interest income............................ 1,088 1,015 1,018 918
Non-interest expense........................... 4,702 4,846 4,814 4,410
------ ----- ----- -----
Income before provision for income taxes..... 1,743 1,779 2,157 2,637
Provision for income taxes..................... 636 647 777 899
------ ----- ----- -----
Net income................................. $1,107 1,132 1,380 1,738
====== ===== ===== =====
Basic earnings per share....................... $ 0.10 0.11 0.13 0.16
Diluted earnings per share..................... 0.10 0.10 0.13 0.16
Cash dividends declared........................ 0.055 0.06 0.065 0.07
Six Months
Ended December
31, 1998
---------------
First Second
Quarter Quarter
------- -------
Interest income............................................. $9,068 9,141
Interest expense............................................ 3,618 3,574
------ -----
Net interest income....................................... 5,450 5,567
Provision for loan losses................................... 100 102
------ -----
Net interest income after provision for loan losses....... 5,350 5,465
Non-interest income......................................... 1,279 1,622
Non-interest expense........................................ 4,469 5,806
------ -----
Income before provision for income taxes.................. 2,160 1,281
Provision for income taxes.................................. 799 477
------ -----
Net income................................................ $1,361 804
====== =====
Basic earnings per share.................................... $ 0.13 0.07
Diluted earnings per share.................................. 0.12 0.07
Cash dividends declared..................................... 0.045 0.05
F-30
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Year ended June 30, 1998
-------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
Interest income................................ $6,217 6,598 7,312 7,850
Interest expense............................... 2,815 3,017 2,953 3,082
------ ----- ----- -----
Net interest income.......................... 3,402 3,581 4,359 4,768
Provision for loan losses...................... 35 36 39 39
------ ----- ----- -----
Net interest income after provision for loan
losses...................................... 3,367 3,545 4,320 4,729
Non-interest income............................ 1,009 988 1,169 1,095
Non-interest expense........................... 3,178 3,319 3,491 3,702
------ ----- ----- -----
Income before provision for income taxes..... 1,198 1,214 1,998 2,122
Provision for income taxes..................... 422 420 686 744
------ ----- ----- -----
Net income................................... $ 776 794 1,312 1,378
====== ===== ===== =====
Basic earnings per share....................... $ 0.08 0.08 0.13 0.13
Diluted earnings per share..................... 0.08 0.08 0.12 0.12
Cash dividends declared........................ NM NM 0.035 0.04
Cash dividends prior to January 1998 stock offering and conversion are not
comparable to prior periods due to the former mutual holding company's waiver
of its pro rata cash dividends.
F-31
EXHIBIT INDEX
Exhibit
No.
-------
3.1 Articles of Incorporation(1)
3.2 Bylaws of the Company(1)
10.1 1998 Stock Option and Restricted Stock Award Plan(2)
Employment Agreement between the Company and Donald V. Rhodes,
10.2 effective October 1, 1997.(1)
Severance Agreement between the Company and Brian L. Vance, effective
10.3 October 1, 1997.(1)
Severance Agreement between the Company and John D. Parry, effective
10.4 October 1, 1997(1)
10.5 Form of Severance Agreement entered into between the Company and seven
additional executives, effective as of October 1, 1997.(1)
10.6 1997 Stock Option and Restricted Stock Award Plan(3)
21.0 Subsidiaries of the Company
23.0 Consent of KPMG LLP
24.0 Power of Attorney dated February 17, 2000
27.0 1999 Financial Data Schedule
- --------
(1) Incorporated by reference to the Registration Statement on Form S-1 (Reg.
No. 333-35573) declared effective on November 12, 1997.
(2) Incorporated by reference to the definitive Proxy Statement dated
September 14, 1998 for the Annual Meeting of Shareholders held on October
15, 1998.
(3) Incorporated by reference to the Registration Statement on Form S-8 (Reg.
No. 333-57513).