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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, 2000
[_] 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 $56,460,868 and is based upon the last sales price as quoted on
the NASDAQ Stock Market for March 2, 2001.
The Registrant had 8,161,005 shares of common stock outstanding as of March
2, 2001.
DOCUMENTS TO BE INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement dated March 22, 2001
for the 2001 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, 2000
INDEX
Page
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PART I
ITEM 1. BUSINESS...................................................... 3
LENDING ACTIVITIES............................................ 4
INVESTMENT ACTIVITIES......................................... 11
DEPOSIT ACTIVITIES AND OTHER SOURCES OF FUNDS................. 13
SUPERVISION AND REGULATION.................................... 17
COMPETITION................................................... 21
ITEM 2. PROPERTIES.................................................... 22
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.... 36
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................... 37
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURES.................................... 37
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............ 38
ITEM 11. EXECUTIVE COMPENSATION........................................ 38
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT................................................... 38
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................ 38
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
FORM 10-K.................................................... 39
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 five branch
offices located in Yakima and Kittitas Counties.
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, income property, 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 Bancshares for all periods presented. Effective June
12, 1998 we acquired North Pacific Bank in a transaction accounted for as a
purchase. North Pacific Bank was 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, 2000 will be the second 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 and
Central Valley Bank. 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. Central Valley Bank from
six full service offices, five in Yakima County, and one in Kittitas County.
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
26% of the total county work force. Federal, county and municipal government
together comprise nearly 40% of the county's civilian employment base.
3
Thurston County has a population of 204,300 as of April 1, 2000 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
706,000 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 49,477 in 2000. The largest
employer in the county is government, but its economy is substantially
dependent upon the timber and forest products industries.
Yakima County is located in central Washington. It has a population of
approximately 212,000, and its economy is substantially dependent upon
agriculture. Yakima County is a leading producer of tree fruits, hops, and
other agricultural products.
Lending Activities
General. Our lending activities are carried on through the two banks,
Heritage Bank and Central Valley Bank. We offer commercial, real estate,
income property, agricultural, and consumer loans. Reflecting our efforts to
broaden our products and services to those more closely related to commercial
banking, commercial lending has been our focus in recent years. These efforts
contributed to an increase in commercial loans to $234.2 million, or 48.6% of
total loans, as of December 31, 2000 from $192.1 million, or 46.0% of total
loans, as of December 31, 1999. We continue to provide real estate mortgages,
both single and multi family residential and commercial. Real estate mortgages
increased to $217.1 million, or 45% of total loans at December 31, 2000, from
$192.1 million, or 46% of total loans at December 31, 1999. As we pursue our
strategy to focus on commercial lending, management continues 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.
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,
---------------------------------- ----------------------------------------------------
1997 1998 1998 1999 2000
---------------- ---------------- ---------------- ---------------- ----------------
% of % of % of % of % of
Balance Total Balance Total Balance Total Balance Total Balance Total
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
(Dollars in thousands)
Commercial.............. $ 53,994 22.22% $117,655 37.46% $128,171 39.20% $192,088 45.98% $234,166 48.55%
Real Estate Mortgages
One-four family
residential (1)....... 107,010 44.02 100,753 32.07 97,277 29.76 97,907 23.44 107,501 22.28
Five or more family
residential and
commercial
properties............ 66,260 27.26 72,406 23.05 70,139 21.45 94,242 22.56 109,560 22.71
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total real estate
mortgages........... 173,270 71.28 173,159 55.12 167,416 51.21 192,149 46.00 217,061 44.99
Real estate construction
One-four family
residential........... 13,142 5.41 19,505 6.21 26,640 8.15 23,293 5.58 27,412 5.68
Five or more family
residential and
commercial
properties............ 1,029 0.42 527 0.17 2,123 0.65 7,537 1.80 -- --
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total real estate
construction (2).... 14,171 5.83 20,032 6.38 28,763 8.80 30,830 7.38 27,412 5.68
Consumer................ 2,692 1.11 4,477 1.43 4,001 1.22 4,273 1.02 5,466 1.13
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total loans............. 244,127 100.44% 315,323 100.39% 328,351 100.43% 419,340 100.38% 484,105 100.35%
Less deferred loan fees
and other.............. (1,079) -0.44 (1,228) -0.39 (1,400) -0.43 (1,578) -0.38 (1,670) -0.35
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Net loans............... $243,048 100.00% $314,095 100.00% $326,951 100.00% $417,762 100.00% 482,435 100.00%
======== ====== ======== ====== ======== ====== ======== ====== ======== ======
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(1) Includes loans held for sale of $6,323, $6,411, $7,618, $589, and $1,931,
respectively.
(2) Balances are net of undisbursed loan proceeds.
The following table presents at December 31, 2000, (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............................... $ 79,427 $44,725 $110,014 $234,166
Real estate construction................. 24,511 2,274 627 27,412
-------- ------- -------- --------
Total.................................. $103,938 $46,999 $110,641 $261,578
======== ======= ======== ========
Fixed rate loans......................... $33,322 $ 29,899 $ 63,221
Variable or adjustable rate loans........ 13,677 80,742 94,419
------- -------- --------
Total.................................. $46,999 $110,641 $157,640
======= ======== ========
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
policy is not to make ARMs with discounted initial interest rates (i.e.,
"teasers"). We generally sell all
5
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. 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
generally 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. Commercial 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, 2000, we had $234.2 million, or 48.5% of our total loans
receivable, in commercial loans. 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). However, we
serviced $13.1 million, $9.5 million and $7.9 million in mortgage loans for
others as of December 31, 1998, December 31, 1999 and December 31, 2000,
respectively. We received fee income of $22,000, $34,000 and $27,000 for the
six months ended December 31, 1998, year ended December 31, 1999 and December
31, 2000 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 months Year ended
Year ended ended December 31
June 30, December 31 ---------------
1998 1998 1999 2000
---------- ----------- ------- -------
(Dollars in thousands)
One- to four-family residential
mortgage loans:
Originated....................... $118,774 $68,434 $78,248 $55,630
Sold............................. 101,903 57,490 58,266 35,876
Gains on sales of loans, net....... $ 2,406 $ 1,297 $ 1,079 $ 684
We have a minimal amount of purchased mortgage loans and mortgage 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, 2000, we had outstanding commitments to extend
credit, including letters of credit, in the amount of $94.9 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 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 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 there from 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 (Division), the Office of the Comptroller of
the Currency (OCC), 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 considered uncollectible and of such
little value that continuance as an asset of the institution is not warranted.
8
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 Division of Banks completed the most recent examination of Heritage Bank
in March 2000. The Office of the Comptroller of the Currency examined Central
Valley Bank 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 FDIC was in progress during March 2001.
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,
------------------ -------------------------
1997 1998 1998 1999 2000
-------- -------- ------- ------- -------
(Dollars in thousands)
Nonaccrual loans............... $ 146 $ 385 $ 401 $ 1,804 $ 1,607
Restructured loans............. -- -- -- -- --
-------- -------- ------- ------- -------
Total nonperforming loans.... 146 385 401 1,804 1,607
Real estate owned.............. -- 82 -- -- --
-------- -------- ------- ------- -------
Total nonperforming assets... $ 146 $ 467 $ 401 $ 1,804 $ 1,607
-------- -------- ------- ------- -------
Accruing loans past due 90 days
or more....................... $ -- $ 15 $ 8 $ -- $ 1,086
Potential problem loans........ 239 1,758 877 2,826 2,422
Allowance for loan losses...... 3,105 3,929 3,957 4,264 5,063
Nonperforming loans to loans... 0.06% 0.12% 0.12% 0.43% 0.33%
Allowance for loan losses to
loans......................... 1.28% 1.25% 1.21% 1.02% 1.05%
Allowance for loan losses to
nonperforming loans........... 2133.01% 1019.90% 984.70% 236.27% 315.02%
Nonperforming assets to total
assets........................ 0.05% 0.10% 0.08% 0.35% 0.28%
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, is less than fully collateralized, and is not in the process of
collection. 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 $10,807, $59,613 and $129,612 for
the six months ended December 31, 1998, and the years ended December 31, 1999
and December 31, 2000, respectively. Previous period interest foregone was
immaterial.
Potential Problem Loans. We include in "potential problem loans" loans which
are currently accruing interest but which we have information about possible
credit problems of borrowers which cause us to have serious doubt as to the
ability of the borrowers to comply with the present repayment and which may
result in placing the loan on nonaccrual status. There is one credit for
$899,000 in the year-end totals that is classified as a potential problem
loan. We expect to foreclose on this loan in the first quarter of 2001. This
credit was classified as performing due to the strength of the underlying
collateral.
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
9
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 four 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 four 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, 2000,
we experienced net recoveries of $12,000. 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 four
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
Year Ended June 30, Ended December 31,
-------------------- December 31, -------------------
1997 1998 1998 1999 2000
--------- --------- ------------ -------- --------
(Dollars in thousands)
Total loans outstanding
at end of period(1).... $ 243,048 $ 314,095 $326,952 $417,762 $482,435
--------- --------- -------- -------- --------
Average loans
outstanding during
period................. $ 213,560 $ 251,816 $319,645 $361,116 $445,813
--------- --------- -------- -------- --------
Allowance balance at
beginning of period.... $ 2,221 $ 3,105 $ 3,929 $ 3,957 $ 4,264
Provision for loan
losses................. (265) 149 202 408 787
Allowance acquired with
North Pacific Bank..... -- 670 -- --
Charge-offs:
Real estate(2)........ -- -- (36) (120) (4)
Commercial............ (2) -- (146) (117) (34)
Consumer.............. (7) (3) (5) (10) (2)
--------- --------- -------- -------- --------
Total charge-offs... (9) (3) (187) (247) (40)
--------- --------- -------- -------- --------
Recoveries:
Real estate(2)........ 1,155 4 4 113 22
Commercial............ 3 1 9 32 29
Consumer.............. -- 3 -- 1 1
--------- --------- -------- -------- --------
Total recoveries.... 1,158 8 13 146 52
--------- --------- -------- -------- --------
Net (charge-offs)
recoveries....... 1,149 5 (174) (101) 12
--------- --------- -------- -------- --------
Allowance balance at end
of period.............. $ 3,105 $ 3,929 $ 3,957 $ 4,264 $ 5,063
========= ========= ======== ======== ========
Ratio of net (charge-
offs) recoveries during
period to average loans
outstanding............ 0.54% 0.00% 0.05% (0.03%) 0.00%
========= ========= ======== ======== ========
- --------
(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,
------------------------------- -----------------------------------------------
1997 1998 1998 1999 2000
--------------- --------------- --------------- --------------- ---------------
% 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)
------ -------- ------ -------- ------ -------- ------ -------- ------ --------
(Dollars in thousands)
Balance applicable to:
Commercial.................. $1,242 22.1% $2,217 37.4% $2,670 39.2% $3,070 45.8% $3,644 48.4%
Real estate mortgages:
One-to four-family
residential.............. 164 43.9 156 32.0 156 29.6 168 23.3 200 22.2
Five or more family
residential and commercial
properties................ 900 27.2 678 22.9 669 21.3 721 22.5 856 22.6
Real estate construction:
One- to four-family
residential............... 202 5.3 214 6.1 135 8.1 145 5.6 274 5.7
Five or more family
residential
and commercial properties.. 31 0.4 10 0.2 16 0.6 17 1.8 20 --
Consumer.................... 20 1.1 53 1.4 54 1.2 58 1.0 69 1.1
Unallocated................. 546 601 257 85 --
------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Total..................... $3,105 100.0% $3,929 100.0% $3,957 100.0% $4,264 100.0% $5,063 100.0%
====== ===== ====== ===== ====== ===== ====== ===== ====== =====
- --------
(1) Represents the total of all outstanding loans in each category as a
percent of total loans outstanding.
Investment Activities
At December 31, 2000, our investment securities portfolio totaled $38.8
million, consisting of $33.7 million of securities available for sale and $5.1
million of securities held to maturity. This compares with a total portfolio
of $42.5 million at December 31, 1999, comprised of $36.4 million of
securities available for sale and $6.1 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, 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
======= ==== ===== =======
December 31, 2000
U.S. Government and its agencies...... $30,796 $ 19 $(126) $30,689
Collateralized mortgage obligations... 1,377 -- (19) 1,358
Corporate notes and other............. 1,600 128 (4) 1,724
------- ---- ----- -------
Totals.............................. $33,773 $147 $(149) $33,771
======= ==== ===== =======
We had no securities available for trading at June 30, 1998, December 31,
1998, December 31, 1999, or December 31, 2000.
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, 2000.
At December 31, 2000
------------------------
Weighted
Book Fair Average
Value Value Yield
------- ------- --------
(Dollars in thousands)
Obligations of US Government agencies:
Due within one year.................................. $15,506 $15,442 5.39%
Due after 1 year but within 5 years.................. 15,290 15,247 5.79
------- -------
30,796 30,689
------- -------
Corporate notes and other investments:
Due after 1 year but within 5 years.................. 1,500 1,496 5.71
Due after 10 years................................... 100 228 --
------- -------
1,600 1,724
------- -------
Collateralized mortgage obligations:
Due after 5 years but within 10 years................ 295 293 6.00
Due after 10 years................................... 1,082 1,065 7.41
------- -------
1,377 1,358
------- -------
Total all investments available for sale............... $33,773 $33,771
======= =======
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 Losses
Amortized Unrealized Gross Fair
Cost Gains Unrealized Value
--------- ---------- ---------- ------
(Dollars in thousands)
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
====== ==== ==== ======
December 31, 2000:
U.S. Government and its agencies....... $ 900 $-- $ (1) $ 899
Mortgage backed securities............. 1,966 90 -- 2,056
Municipal bonds........................ 2,210 14 (5) 2,219
------ ---- ---- ------
Total held for investment............ $5,076 $104 $ (6) $5,174
====== ==== ==== ======
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, 2000.
At December 31, 2000
----------------------
Weighted
Book Fair Average
Value Value Yield(1)
------ ------ --------
(Dollars in thousands)
Obligations of US Government agencies:
Due within one year.................................... $ 900 $ 899 5.99%
------ ------
900 899
------ ------
Municipal bonds:
Due within one year.................................... 390 390 6.04
Due after 1 year but within 5 years.................... 1,395 1,399 6.57
Due after 5 years but within 10 years.................. 425 430 6.46
------ ------
2,210 2,219
------ ------
Mortgage backed securities:
Due within one year.................................... 32 34 8.25
Due after 1 year but within 5 years.................... 39 39 8.05
Due after 5 years but within 10 years.................. 289 298 8.75
Due after 10 years..................................... 1,606 1,685 8.06
------ ------
1,966 2,056
------ ------
Total all investments held to maturity............... $5,076 $5,174
====== ======
- --------
(1) Taxable equivalent weighted average yield.
We held $2.6 million of FHLB stock at December 31, 2000. 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, 2000, we were required to
maintain an investment in the stock of the FHLB of Seattle of at least $1.2
million.
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,
13
competition, economic condition and other factors, are not. Our deposit
balances increased by $55.2 million in 2000. 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, 2000, 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 one to five years and which require a minimum deposit of $100. In
addition, we offer a CD that has a maturity of three to eleven months and a
minimum deposit of $2,500, and permits additional deposits at the initial rate
throughout the certificate term. Interest is compounded daily and 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:
Six Months
Year Ended Ended Year Ended December 31,
June 30, December 31, ---------------------------------
1998 1998 1999 2000
---------------- ---------------- ---------------- ----------------
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............... $ 62,577 3.12% $ 82,746 2.82% $ 91,281 2.69% $ 99,089 2.81%
Savings................. 41,863 3.50 63,986 3.48 68,484 3.33 62,594 3.56
Certificates of
deposit................ 150,970 5.56 177,956 5.46 165,490 5.00 226,335 6.02
-------- -------- -------- --------
Total interest bearing
deposits............. 255,410 4.62 324,688 4.40 325,255 4.00 388,018 4.80
Demand and other
noninterest bearing
deposits............... 22,759 -- 36,540 -- 37,906 -- 44,038 --
-------- ---- -------- ---- -------- ---- -------- ----
Total deposits........ $278,169 4.25% $361,228 3.95% $363,161 3.58% $432,056 4.31%
======== ==== ======== ==== ======== ==== ======== ====
- --------
(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.
Six months Year Ended
Year Ended Ended December 31,
June 30, December 31, ------------------
1998 1998 1999 2000
---------- ------------ -------- --------
(Dollars in thousands)
Net increase (decrease) in
deposits...................... $109,505 $ 3,469 $ 38,070 $ 55,166
Less: Interest credited...... (11,494) (6,482) (12,631) (18,456)
-------- ------- -------- --------
Net increase(decrease) before
interest credited............. $ 98,011 $(3,013) $ 25,439 $ 36,710
======== ======= ======== ========
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, 2000:
December 31,
2000
------------
(Dollars in
thousands)
Remaining maturity:
Three months or less...................................... $65,236
Over three months through six months...................... 19,733
Over six months through 12 months......................... 10,375
Over twelve months........................................ 725
-------
Total................................................... $96,069
=======
15
At December 31, 1999 and December 31, 2000 certificates of deposits with
balances of $100,000 or more totaled $77.0 million and $96.1 million,
respectively.
Borrowings. Savings deposits are the primary source of funds for our lending
and investment activities and for the general business purposes of Heritage
Bank and Central Valley Bank. 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 at both Heritage Bank and Central Valley Bank. 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. At Central Valley Bank we
also have the ability to purchase federal funds up to $3.6 million with Key
Bank. At the holding company level we maintain a line of credit for $5 million
with Key Bank to supplement any cash needs not covered by dividends from the
banks or earnings from investments retained from proceeds of the conversion.
The FHLB functions as a central reserve bank providing credit for member
financial institutions. As members, Heritage Bank and Central Valley Bank are
required to own capital stock in the FHLB and are 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. 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 year ended June
30, 1998, the six months ended December 31, 1998, the years ended December 31,
1999, and December 31, 2000:
At or for At or for the At or for the
the year six months year ended
ended ended December 31,
June 30, December 31, ---------------
1998 1998 1999 2000
--------- ------------- ------ -------
(Dollars in thousands)
Balance at period end............. $ 890 $ 687 $2,800 $23,125
Average balance during the
period........................... 27 693 958 10,451
Maximum amount outstanding at any
month end........................ 1,300 696 3,300 23,125
Average interest rate:
During the period............... 5.47% 6.20% 5.90% 6.58%
At period end................... 6.45% 6.20% 5.70% 6.81%
16
The following table is a summary of other borrowed funds for the year ended
June 30, 1998 the six months ended December 31, 1998, the years ended December
31, 1999, and December 31, 2000.
At or for
At or for the the year
six months ended
At or for the year ended December 31,
ended June 30, December 31, -------------
1998 1998 1999 2000
------------------ ------------- ----- ------
(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........ $ 320 $ 17 $ 8 $ --
Average balance during the
period...................... 451 93 12 2
Maximum amount outstanding at
any month end............... 547 319 16 7
Average interest rate:
During the period.......... 9.23% 7.29% 0.00% 0.00%
At period end.............. 8.61% 0.00% 0.00% 0.00%
Fed Funds Purchased:
Balance at period end $ -- $ -- $ -- $1,000
Average balance during the
period...................... -- -- 20 501
Maximum amount outstanding at
any month end............... -- -- -- 1,300
Average interest rate:
During the period.......... -- -- 5.41% 6.84%
At period end.............. -- -- -- 7.13%
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. This note was paid off
in September 2000.
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.
17
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 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 regulation by 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.
18
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 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, 2000.
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,
19
. 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 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.
20
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.
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, 2000, we had 211 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.
21
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,
2000, 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 six offices, five located in Yakima County and one in Kittitas County
(five of which are owned with one on leased land, and one office is leased).
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 under the symbol
HFWA. At December 31, 2000, we had approximately 1,434 stockholders of record
(not including the number of persons or entities holding stock in nominee or
street name through various brokerage firms) and 8,222,988 outstanding shares
of common stock. The last reported sales price on March 2, 2001 was $10.125
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.
2000 Quarter ended:
-----------------------------------------
March 31 June 30 September 30 December 31
-------- ------- ------------ -----------
High............................. $8.63 $8.69 $9.88 $10.19
Low.............................. $7.50 $7.13 $8.50 $ 8.75
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, 2000 January 27, 2000
March 17, 2000................. $0.075 April 14, 2000 April 28, 2000
June 16, 2000.................. $0.080 July 14, 2000 July 28, 2000
September 21, 2000............. $0.085 October 16, 2000 October 27, 2000
December 22, 2000.............. $0.090 January 19, 2001 January 31, 2001
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 year
For the six ended December
For the year ended June 30, months ended 31,
------------------------------- December 31, ------------------
1996 1997 1998 1998 1999 2000
--------- --------- --------- ------------ -------- --------
(Dollars in thousands, except per share data)
Operations Data:
Net interest income..... $ 10,504 $ 12,043 $ 16,110 $ 11,017 $ 23,458 $ 24,841
Provision for loan
losses................. -- (265) 149 202 408 787
Noninterest income...... 4,794 3,748 4,261 2,901 4,038 4,190
Noninterest expense..... 10,505 13,445 13,690 10,275 18,773 19,323
Provision (benefit) for
income taxes........... 1,617 12 2,273 1,275 2,958 2,947
Net income.............. 3,176 2,598 4,259 2,166 5,357 5,974
Earnings per share
Basic................. 0.31 0.25 0.41 0.20 0.50 0.66
Diluted............... 0.31 0.24 0.40 0.20 0.49 0.65
Dividend payout ratio
(1).................... NM NM 18.4% 47.3% 50.1% 50.2%
Performance Ratios:
Net interest spread..... 4.14% 4.30% 4.14% 4.13% 4.55% 4.12%
Net interest margin
(2).................... 4.63% 4.80% 5.05% 5.16% 5.49% 5.04%
Efficiency ratio (3).... 68.67% 85.15% 67.20% 73.83% 68.27% 66.56%
Return on average
assets................. 1.27% 0.94% 1.23% 0.92% 1.14% 1.11%
Return on average
equity................. 11.30% 8.74% 6.77% 4.36% 5.32% 6.66%
At June 30, At December 31,
------------------------------- -------------------------------
1996 1997 1998 1998 1999 2000
--------- --------- --------- ------------ -------- --------
Balance Sheet Data:
Total assets............ $ 262,428 $ 291,323 $ 471,030 $475,871 $510,958 $573,530
Loans receivable, net... 191,400 233,621 303,754 315,376 412,909 475,441
Loans held for sale..... 5,287 6,322 6,412 7,618 589 1,931
Deposits................ 226,951 254,024 363,529 366,998 405,068 460,234
Federal Home Loan Bank
advances............... -- 890 698 687 2,800 23,125
Other borrowings........ -- 525 1,633 17 8 1,000
Stockholders' equity.... 29,161 31,588 98,593 100,559 95,264 83,005
Book value per share NM NM $ 9.20 $ 9.27 $ 9.50 $ 10.09
Equity to assets ratio.. 11.11% 10.84% 20.93% 21.13% 18.68% 14.47%
Asset Quality Ratios:
Nonperforming loans to
loans.................. 0.03% 0.06% 0.06% 0.12% 0.43% 0.33%
Allowance for loan
losses to loans........ 1.12% 1.28% 1.25% 1.21% 1.02% 1.05%
Allowance for loan
losses to nonperforming
loans.................. 3398.23% 2133.01% 1019.90% 984.70% 236.27% 315.02%
Nonperforming assets to
total assets........... 0.02% 0.05% 0.10% 0.08% 0.35% 0.28%
Other Data:
Number of banking
offices................ 10 12 14 16 17 18
Number of full-time
equivalent employees... 145 170 180 229 222 211
- --------
(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,
2000 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
included, geographic and product expansion , loan portfolio diversification,
development of relationship banking and maintenance of asset quality.
In the fiscal year ended June 30, 1998, our growth strategy was bolstered by
two significant events, the January 1998 stock offering and conversion, and
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 our 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 all cash transaction was
accounted for using purchase accounting rules. The acquisition of North
Pacific Bank provided further geographical expansion into the Pierce County
market area and enhanced expertise in commercial banking. 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.
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 Bancshares, Inc. 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
Bancshares, Inc. for all periods presented.
In 1999 we were continuing to operate with capital levels well in excess of
regulatory requirements and well in excess of our internal needs. We
determined that buying our own shares with some of our excess capital was the
best use of this capital and we began to buy back shares of company's
outstanding shares. We began in April 1999 with the repurchase of 100,000
shares of our outstanding common stock for $0.8 million, or $8.56 per share.
In October of 1999, we began the first of three stock repurchase programs. The
first totaling 1,082,389 shares, or 10% of the then outstanding shares was
commenced in October 1999 and completed in February 2000. The second totaling
976,748 shares, or 10% of the then outstanding shares was commenced in
February 2000 and completed in August 2000. The third program for a total of
890,000 shares representing 10% of the then
25
outstanding shares was commenced in August 2000 of which 611,232 shares were
repurchased as of December 31, 2000. Collectively as of December 31, 2000, we
have repurchased 2,673,467 shares of our stock representing 24% of the total
outstanding as of September 30, 1999 at an average price of $8.63.
In 2000 we conducted an extensive review of our strategic direction
culminating in a new strategic plan that reaffirmed our 1994 goals with an
increased emphasis on return on average equity and efficiency of operations.
In pursuit of this strategy we announced in January 2001 an initiative titled
"Vision 2001" for Heritage Bank. To assist us we have engaged Alex Sheshunoff
Management Services, L.P. (ASM). ASM completed an opportunities assessment
during fiscal year 2000 for Heritage Bank with the objective of determining
ways that we can optimize our earnings performance. Beginning in March 2001,
ASM will work with us to implement those opportunities identified. We
anticipate that the majority of the costs associated with Vision 2001 will be
incurred by the second quarter of 2001. By year end the affect on full year
2001 earnings should be neutral, with significant improvements in future
years.
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 2000
------------------------- ------------------------- -------------------------
Average Interest Average Interest Average Interest
Balance Earned/ Average Balance Earned/ Average Balance Earned/ Average
(1) Paid Rate (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% $445,813 $41,510 9.31%
Mortgage Backed
Securities............. 3,934 340 8.64 2,773 227 8.19 2,174 180 8.27
Investment securities
and FHLB stock......... 37,768 1,999 5.29 44,270 2,591 5.85 41,885 2,393 5.71
Interest earning
deposits............... 60,374 3.330 5.52 18,745 820 4.37 2,898 159 5.50
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest earning
assets................. 391,821 $33,372 8.52% 426,904 $36,524 8.56% 492,770 $44,242 8.98%
Noninterest earning
assets................. 35,274 44,637 47,394
-------- -------- --------
Total assets........... $427,095 $471,541 $540,164
======== ======== ========
Interest Bearing
Liabilities:
Certificates of
deposit................ $166,818 $ 9,168 5.50% $165,490 $ 8,271 5.00% $226,334 $13,617 6.02%
Savings accounts........ 53,264 1,836 3.45 68,484 2,279 3.33 62,594 2,226 3.56
Interest bearing demand
and money market
accounts............... 73,512 2,145 2.92 91,281 2,458 2.69 99,089 2,787 2.81
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing
deposits............... 293,594 13,149 4.48 325,255 13,008 4.00 388,017 18,630 4.80
FHLB advances........... 381 22 5.67 1,021 57 5.53 10,441 722 6.92
Other borrowed funds.... 674 57 8.46 37 1 3.54 477 49 10.16
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing
liabilities........... 294,649 $13,228 4.49% 326,313 $13,066 4.00% $398,935 $19,401 4.86%
Demand and other
noninterest bearing
deposits............... 28,932 37,906 44,038
Other noninterest
bearing liabilities.... 6,473 6,712 7,463
Stockholders' equity.... 97,041 100,610 89,728
-------- -------- --------
Total liabilities and
stockholders' equity... $427,095 $471,541 $540,164
======== ======== ========
Net interest income..... $20,144 $23,458 $24,841
Net interest spread..... 4.03% 4.55% 4.12%
Net interest margin..... 5.14% 5.49% 5.04%
Average interest earning
assets to average
interest bearing
liabilities............ 132.98% 130.83% 123.52%
- --------
(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 8 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............... 4,354 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
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 1999 Compared to 2000
Increase(Decrease) Increase(Decrease Due
Due to to
----------------------- ------------------------
Volume Rate Total Volume Rate Total
------ ------- ------ ------- ------- ------
Interest Earning Assets:
Loans...................... $6,824 $(1,641) $5,183 $ 7,713 $ 910 $8,623
Mortgage backed
securities................ (100) (13) (113) (49) 2 (47)
Investment securities and
FHLB stock................ 344 248 592 (140) (58) (198)
Interest earning deposits.. (2,296) (214) (2,510) (693) 33 (660)
------ ------- ------ ------- ------- ------
Total interest income.... $4,772 $(1,620) $3,152 $ 6,831 $ 887 $7,718
====== ======= ====== ======= ======= ======
Interest bearing
liabilities:
Certificates of deposit.... 73 824 897 (3,041) (2,305) (5,346)
Savings accounts........... (525) 82 (443) 196 (143) 53
Interest bearing demand and
money market accounts..... (519) 206 (313) (210) (118) (328)
------ ------- ------ ------- ------- ------
Total interest bearing
deposits................ (971) 1,112 141 (3,055) (2,566) (5,621)
FHLB advances.............. (36) 1 (35) (522) (144) (666)
Other borrowings........... 54 2 56 (16) (32) (48)
------ ------- ------ ------- ------- ------
Total interest bearing
liabilities............. $ (953) $ 1,115 $ 162 $(3,593) $(2,742) (6,335)
====== ======= ====== ======= ======= ======
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)
======= ===== =======
29
Financial Condition
Our total assets grew $62.6 million (12.2%) to $573.5 million at December
31, 2000 from $511.0 million at December 31, 1999. Deposits grew $55.2 million
(13.6%) to $460.2 million at December 31, 2000 from $405.1 million at December
31, 1999. Total loans grew by $64.7 million (15.5%) to $482.4 million at
December 31, 2000 from $417.7 million at December 31, 1999. $42.1 million
(65.1%) of the loan growth was in commercial loans as they grew to $234.2
million at December 31, 2000 from $192.1 million at December 31, 1999, an
increase of 21.9%.
On April 26, 1999 our board of directors authorized the repurchase of
100,000 shares of our common stock which was completed for $0.8 million, or
$8.56 per share. In October of 1999, we began the first of three stock
repurchase programs. The first totaling 1,082,389 shares, or 10% of the then
outstanding shares was commenced in October 1999 and completed in February
2000. The second totaling 976,748 shares, or 10% of the then outstanding
shares was commenced in February 2000 and completed in August 2000. The third
program for a total of 890,000 shares representing 10% of the then outstanding
shares was commenced in August 2000 of which 611,232 shares were repurchased
as of December 31, 2000. Collectively as of December 31, 2000, we have
repurchased 2,673,467 shares of our stock representing 24% of the total
outstanding as of September 30, 1999 at an average price of $8.63. Subsequent
to December 31, 2000 we have purchased an additional 81,300 shares at an
average price of $10.12 bringing the total purchased through March 2, 2001 to
2,754,767 shares at an average price of $8.67.
Results of Operations for the Years Ended December 31, 2000 and 1999
Net Income. Our net income was $6.0 million or $0.65 per diluted share for
the year ended December 31, 2000 as compared to $5.4 million or $0.49 per
diluted share for the same period last year. The growth in income primarily
resulted from a $65.9 million growth in average earning assets for the year
2000 compared to 1999. Average costing liabilities grew $72.6 million
contributing to a narrowing margin. The difference in growth between average
earning assets and costing liabilities is the result of stock repurchases
during the year.
Net Interest Income. Net interest income increased $1.4 million (5.9%), for
the year ended December 31, 2000 compared with the same period last year,
primarily as a result of the $84.7 million (23.5%) increase in the average
balance of loans. Average interest earning assets grew $65.9 million (15.4%)
as average short term investments (primarily overnight deposits) decreased by
$18.8 million (28.6%). The reduction of short term investments was used along
with the growth in average deposits of $62.8 million (19.3%) to fund loan
growth and repurchase stock.
Net interest income as a percentage of average earning assets (net interest
margin) for the year ended December 31, 2000 decreased to 5.04% from 5.49% for
the same period last year. The decrease resulted from the strong growth in
average deposits, particularly Certificates which grew $60.8 million ($36.8%)
and which have a higher cost associated with them. During 1998 and 1999 we
were able to utilize our excess capital from the January 1998 proceeds of the
Conversion to reduce our reliance on higher costing sources of funds. With the
stock repurchase beginning in the fourth quarter of 1999 we have reduced our
excess capital levels to the benefit of our return on average equity and
earnings per share but at the expense of a greater reliance on costing
liabilities. Our net interest spread for the year ended December 31, 2000
decreased to 4.12% from 4.55% for the prior year. This corresponded with the
increase in the average cost of funds to 4.86% for the year ended December 31,
2000 from 4.00% for the same period last year. These rate shifts resulted from
the increased demand for funds to support loan growth and the stock
repurchase.
Provision for Loan Losses. During the year ended December 31, 2000,we
provided $787,000 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, 2000, we experienced net
recoveries of $12,000. This improved our allowance for loan loss to total loan
ratio to 1.05% at December 31, 2000 from 1.02% at the end of 1999. While our
loan portfolio, and in particular commercial loans, have grown substantially
over the past three years, our asset quality has remained strong as
demonstrated by the nonperforming assets to total assets
30
ratio of 0.28% at December 31, 2000. We did not include one credit for
$899,000 in the year end totals that we now expect to foreclose on in the
first quarter of 2001. This credit was classified as performing due to the
strength of the underlying collateral. Had this credit been included with
nonperforming assets the ratio to total assets would have been a still strong
0.44%. 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, 2000 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 $152,000 (3.8%) for
the year ended December 31, 2000 compared with the prior year. Increases in
service charges on deposits offset the reduction in mortgage banking income.
Service charges on deposits increased $212,000 (15.4%) resulting from
increased service charges and demand for deposit products. Other income
increased $289,000 (24.2%) for 2000 as compared to 1999. The decrease in
mortgage banking income is attributable to the region wide reduction in the
level of mortgage banking activity beginning the second quarter of 1999. Loan
sale gains fell $395,000 (36.6%) to $684,000 for 2000 from $1,079,000 in 1999.
This corresponds with reduced mortgage production of $55.6 million during the
year ended December 31, 2000, down from the prior year production of $78.2
million by $22.6 million (28.9%).
Noninterest Expense. Total noninterest expense increased $550,000 (2.9%) for
the year ended 2000 compared to the 1999 period. Increased personnel and
occupancy costs were offset with reductions in all other categories. Personnel
costs increased $488,000 (5.1%) for 2000 as a result of reduced salary
deferrals resulting from lower loan production. Costs deferred in 2000 were
$663,000 compared to $1,094,000 for 1999, a decrease of $431,000 (39.4%).
Occupancy costs increased $196,000 (6.8%) in 2000 resulting from increased
maintenance and repair expenses, the construction of a new branch to replace
Heritage Bank's old Spanaway branch and the opening of a new branch in
Ellensburg, Washington by Central Valley Bank. Other expenses decreased
$78,000 (2.3%) for 2000 compared to 1999.
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 in 1998. 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 (16.4%), for
the year ended December 31, 1999 compared with the same period in 1998
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 (9.0%) as average interest earning
short term investments (primarily deposits) decreased by $41.6 million (69.0%)
to fund loan growth.
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 in 1998. 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
31
average cost of funds to 4.00% for the year ended December 31, 1999 from 4.49%
for the same period in 1998. 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 $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.
32
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 in 1997. 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
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, 2000 cash and cash equivalents totaled $21.5
million, or 3.7% of total assets. At December 31, 2000, the Banks maintained a
credit facility with the FHLB of Seattle for $107.2 million (of which $23.1
million was outstanding at that date).
To fund growth in 2000, 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 utilize available credit lines. Total deposits increased $55.2 million, or
13.6%, to $460.2 million at December 31, 2000 from $405.1 million at December
31, 1999. The largest increase in deposits occurred in certificates, which
grew $46.6 million (23.3%) to $247.0 million at December 31, 2000 from
$200.4 million at December 31, 1999. Borrowings increased $21.3 million to
$24.1 million, primarily through Federal Home Loan Bank advances which grew to
$23.1 million at December 31, 2000 from $2.8 million at December 31, 1999. 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.
We and our banks are subject to various regulatory capital requirements. As
of December 31, 2000, we and our banks were classified as "well capitalized"
institutions under the criteria established by the FDIC Act.
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 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, low 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 negative
"gap" of 5.95% for the 0-3 month period and a negative one year "gap" of 9.75%
as of December 31, 2000. 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. 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 negative gap for the 0-3
month period indicates that increases in market interest rates may adversely
affect our results over that period.
34
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, 2000 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................... $166,499 $ 90,790 $119,278 $78,802 $25,445 $480,814
Investment securities... 1,513 17,213 17,788 1,714 619 38,847
FHLB stock.............. 2,646 - -- -- -- 2,646
Fed funds sold.......... -- -- -- -- -- --
Interest earning
deposits............... 1,278 -- -- -- -- 1,278
-------- -------- -------- ------- ------- --------
Total interest earning
assets................. $171,936 $108,003 $137,066 $80,516 $26,064 $523,585
Noninterest earning
assets................. 49,945
-------- -------- -------- ------- ------- --------
Total assets.......... $573,530
======== ======== ======== ======= ======= ========
Interest Bearing
Liabilities:
Total interest bearing
deposits............... 184,964 121,904 101,981 -- -- 408,849
FHLB advances and other
borrowings............. 18,125 6,000 -- -- -- 24,125
-------- -------- -------- ------- ------- --------
Total interest bearing
liabilities............ $203,089 $127,904 $101,981 $ -- $ -- $432,974
Noninterest bearing
liabilities and
equity................. 140,556
-------- -------- -------- ------- ------- --------
Total liabilities and
equity............... $573,530
======== ======== ======== ======= ======= ========
Rate sensitivity gap.... $(31,153) $(19,901) $ 35,085 $80,516 $26,064 $ 90,611
Cumulative rate
sensitivity gap:
Amount.................. (31,153) (51,054) (15,969) 64,547 90,611
As a percentage of
interest earning
assets................. (5.95)% (9.75)% (3.05)% 12.33% 17.31%
======== ======== ======== ======= ======= ========
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.
35
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 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. In June 2000, the FASB issued SFAS Statement No. 138, "Accounting
for Certain Derivative Instruments and Certain Hedging Activities", an
amendment of FASB Statement No. 133, which makes minor modifications to SFAS
No. 133. This statement was adopted January 1, 2001 and did not have a
material effect on the results of operations or the financial position of the
Corporation.
In September 2000, The Financial Accounting Standards Board issued SFAS No.
140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities," and replaced SFAS No. 125 of the same title.
This statement revises the standards for accounting for securitizations and
other transfers of financial assets and collateral and requires certain
disclosures, but carries over most of SFAS No. 125's provisions without
reconsideration. This statement is effective for transfers and servicing of
financial assets and extinguishments of liabilities occurring after March 31,
2001 and is effective for recognition and reclassification of collateral and
for disclosures relating to securitization transactions and collateral for
fiscal years ending after December 15, 2000. Management does not expect that
adoption of this statement will have a material effect on the results of
operations or the financial position of the Corporation.
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.
36
The table below provides information as of December 31, 2000 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,
----------------------------------------------------------------
2004- After Fair
2001 2002 2003 2005 2006 Total Value
-------- ------- ------- ------- -------- -------- --------
(Dollars in thousands)
Investment Securities
Amounts maturing:
Fixed rate............ $ 18,230 $10,687 $ 2,784 $ 3,438 $ 3,676 $ 38,815
Weighted average
interest rate........ 5.42% 5.66% 5.61% 5.90% 6.85%
Adjustable Rate....... 32 -- -- -- -- 32
Weighted average
interest rate........ 8.00% -- -- -- --
-------- ------- ------- ------- -------- -------- --------
Totals.............. 18,262 10,687 2,784 3,438 3,676 $ 38,847 $ 38,945
Loans
Amounts maturing:
Fixed rate............ $ 7,044 $ 8,362 $ 5,566 $18,544 $152,527 $192,043
Weighted average
interest rate........ 9.30% 9.39% 8.75% 9.25% 8.58%
Adjustable rate....... 123,707 15,948 13,631 22,076 115,030 290,392
Weighted average
interest rate........ 10.02% 9.44% 9.27% 9.39% 8.79%
-------- ------- ------- ------- -------- -------- --------
Totals.............. $130,751 $24,310 $19,197 $40,620 $267,557 $482,435 $488,358
Certificates of Deposit
Amounts maturing:
Fixed rate............ $241,354 $ 3,636 $ 1,454 $ 557 $ -- $247,001 $248,056
Weighted average
interest rate........ 6.45% 5.78% 5.24% 4.47% --
FHLB Advances
Amounts maturing:
Fixed rate............ $ 23,125 $ -- $ -- $ -- $ -- $ 23,125 $ 23,126
Weighted average
interest rate........ 6.81% -- -- -- --
Other Borrowings
Amounts maturing:
Fixed rate............ $ 1,000 $ -- $ -- $ -- $ -- $ 1,000 $ 1,000
Weighted average
interest rate........ 7.13% -- -- -- --
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 ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
37
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, 2001 (the "Proxy Statement") for
the annual meeting of shareholders to be held April 26, 2001.
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.
38
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)
10.2 Employment Agreement between the Company and Donald V. Rhodes,
effective October 1, 1997.(1)
10.3 Severance Agreement between the Company and Brian L. Vance,
effective October 1, 1997.(1)
10.4 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 March 19, 2001
--------
(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
during 2000 as follows:
(1) February 23, 2000 Form 8-K announcing that the board of
Heritage Financial Corporation authorized the repurchase an
additional 10% of its outstanding stock.
(2) May 24, 2000 Form 8-K announcing that the board of Heritage
Financial Corporation elected Brian Charneski to the board
effective May 17, 2000.
(3) June 28, 2000 Form 8-K announcing that the board of Heritage
Financial Corporation authorized the repurchase of an
additional 10% of its outstanding stock.
39
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 19, 2001
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 19, 2001, as
attorney-in-fact for the following directors who constitute a majority of the
board of directors.
Lynn M. Brunton John A. Clees Brian Charneski
Daryl D. Jensen H. Edward Odegard Jeffrey S. Lyon
James P. Senna Peter Fluetsch
Philip S. Weigand Melvin R. Lewis
/s/ Donald V. Rhodes
-------------------------------------
Donald V. Rhodes
Attorney-in-fact
March 19, 2001
40
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
June 30, 1998, December 31, 1998, 1999, and 2000
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Independent Auditors' Report.............................................. F-2
Consolidated Statements of Financial Condition--December 31, 1999 and
December 31, 2000........................................................ F-3
Consolidated Statements of Income--Year ended June 30, 1998, for the six
month periods ended December 31, 1997 (unaudited) and 1998, and the years
ended December 31, 1998 (unaudited), 1999, and 2000...................... F-4
Consolidated Statements of Stockholders' Equity and Comprehensive Income--
Year ended June 30, 1998, for the six months ended December 31, 1998, and
the years ended December 31, 1999, and 2000.............................. F-5
Consolidated Statements of Cash Flows--Year ended June 30, 1998, for the
six month periods ended December 31, 1997 (unaudited) and 1998, and the
years ended December 31, 1998 (unaudited), 1999, and 2000................ F-6
Notes to Consolidated Financial Statements................................ F-7
F-1
Independent Auditor's 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, 1999 and 2000, and the related consolidated statements of
income, stockholders' equity and comprehensive income, and cash flows for the
year ended June 30, 1998, for the six-month period ended December 31, 1998 and
for each of the years in the two-year period ended December 31, 2000.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. 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, 1999 and
2000, and the results of their operations and their cash flows for the year
ended June 30, 1998, for the six-month period ended December 31, 1998 and for
each of the years in the two-year period ended December 31, 2000 in conformity
with accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
Seattle, Washington
February 4, 2001
F-2
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31, 1999 and 2000
(Dollars in thousands)
December 31
-----------------
1999 2000
-------- -------
ASSETS
------
Cash on hand and in banks................................... $ 17,596 20,187
Interest earning deposits................................... 949 1,278
Federal funds sold.......................................... 2,100 --
Investment securities available for sale.................... 36,378 33,771
Investment securities held to maturity...................... 6,165 5,076
Loans held for sale......................................... 589 1,931
Loans receivable............................................ 417,173 480,504
Less: Allowance for loan losses............................. (4,264) (5,063)
-------- -------
Loans, net................................................ 412,909 475,441
Premises and equipment, at cost, net........................ 18,874 19,510
Federal Home Loan Bank stock, at cost....................... 2,218 2,647
Accrued interest receivable................................. 2,938 3,693
Prepaid expenses and other assets........................... 2,447 2,779
Goodwill.................................................... 7,795 7,217
-------- -------
$510,958 573,530
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Deposits.................................................... $405,068 460,234
Advances from Federal Home Loan Bank........................ 2,800 23,125
Other borrowings............................................ 8 1,000
Advance payments by borrowers for taxes and insurance....... 375 363
Accrued expenses and other liabilities...................... 6,584 5,037
Deferred Federal income taxes............................... 859 766
-------- -------
415,694 490,525
-------- -------
Stockholders' equity:
Common stock, no par, 15,000,000 shares authorized;
10,025,407 and 8,222,988 shares outstanding at December
31, 1999 and December 31, 2000,
respectively............................................. 69,837 54,080
Unearned compensation--ESOP and Other..................... (1,154) (1,074)
Retained earnings, substantially restricted............... 26,926 30,000
Accumulated other comprehensive income, net............... (345) (1)
-------- -------
Total stockholders' equity.............................. 95,264 83,005
Commitments and Contingencies............................. -- --
-------- -------
$510,958 573,530
======== =======
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)
Six Months Ended Year ended
Year Ended December 31, December 31,
June 30, ---------------------- --------------------------------
1998 1997 1998 1998 1999 2000
----------- ----------- ---------- ---------- ---------- ---------
(unaudited) (unaudited)
Interest income:
Loans.................. $ 24,053 11,679 15,329 27,703 32,886 41,510
Mortgage backed
securities............ 397 208 151 340 227 180
Investment securities
and Federal Home Loan
Bank dividends........ 1,298 486 1,186 1,999 2,591 2,393
Interest on federal
funds sold and
overnight deposits.... 2,229 442 1,544 3,330 820 159
----------- ---------- ---------- ---------- ---------- ---------
Total interest
income.............. 27,977 12,815 18,210 33,372 36,524 44,242
----------- ---------- ---------- ---------- ---------- ---------
Interest expense:
Deposits............... 11,810 5,800 7,139 13,149 13,008 18,630
Other borrowings....... 57 32 54 79 58 771
----------- ---------- ---------- ---------- ---------- ---------
Total interest
expense............. 11,867 5,832 7,193 13,228 13,066 19,401
----------- ---------- ---------- ---------- ---------- ---------
Net interest
income............ 16,110 6,983 11,017 20,144 23,458 24,841
Provision for loan
losses................. 149 71 202 280 408 787
----------- ---------- ---------- ---------- ---------- ---------
Net interest income
after provision
for loan losses... 15,961 6,912 10,815 19,864 23,050 24,054
----------- ---------- ---------- ---------- ---------- ---------
Noninterest income:
Gains on sales of
loans, net............ 2,406 1,102 1,297 2,601 1,079 684
Commissions on sales
of annuities and
securities............ 151 75 101 178 184 196
Services charges on
deposits.............. 947 433 661 1,175 1,378 1,590
Rental income.......... 208 104 112 215 205 239
Other income........... 549 284 730 996 1,192 1,481
----------- ---------- ---------- ---------- ---------- ---------
Total noninterest
income.............. 4,261 1,998 2,901 5,165 4,038 4,190
----------- ---------- ---------- ---------- ---------- ---------
Noninterest expense:
Salaries and employee
benefits.............. 7,477 3,677 5,172 8,972 9,616 10,105
Building occupancy..... 2,199 1,077 1,502 2,624 2,870 3,066
FDIC premiums and
special assessment.... 141 67 73 147 155 85
Data processing........ 907 425 683 1,165 1,226 1,195
Marketing.............. 431 208 298 522 450 401
Office supplies and
printing.............. 312 152 209 370 473 410
Goodwill
amortization.......... 12 12 288 288 577 577
Other.................. 2,211 880 2,050 3,380 3,406 3,484
----------- ---------- ---------- ---------- ---------- ---------
Total noninterest
expense............. 13,690 6,498 10,275 17,468 18,773 19,323
----------- ---------- ---------- ---------- ---------- ---------
Income before
Federal income tax
expense
(benefit)......... 6,532 2,412 3,441 7,561 8,315 8,921
Federal income tax
expense (benefit)...... 2,273 842 1,275 2,706 2,958 2,947
----------- ---------- ---------- ---------- ---------- ---------
Net income......... $ 4,259 1,570 2,166 4,855 5,357 5,974
=========== ========== ========== ========== ========== =========
Basic earnings per
common share........... $ 0.41 0.15 0.20 0.46 0.50 0.66
Basic weighted average
shares................. 10,394,415 10,235,550 10,553,279 10,663,238 10,763,066 9,098,604
Diluted earnings per
common share........... $ 0.40 0.15 0.20 0.44 0.49 0.65
Diluted weighted average
shares................. 10,669,706 10,253,887 11,029,597 11,059,915 10,935,397 9,238,888
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,
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
options................ 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 dividends
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
options................ 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 dividends
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
options................ 92 252 -- -- 19 -- 271
Stock repurchased....... (921) (7,878) -- -- -- -- (7,878)
Net income.............. -- -- -- -- 5,357 -- 5,357
Net decrease in
unrealized gain on
securities available
for sale, net
of taxes............... -- -- -- -- -- (471) (471)
Cash dividends
declared............... -- -- -- -- (2,649) -- (2,649)
------ ------- ------ ------ ------ ---- -------
Balance at December 31,
1999................... 10,025 69,837 -- (1,154) 26,926 (345) 95,264
Earned ESOP shares...... 9 (5) 80 75
Exercise of stock
options................ 41 200 200
Stock repurchased....... (1,852) (15,952) (15,952)
Net income.............. 5,974 5,974
Net decrease in
unrealized loss on
securities available
for sale, net of
taxes.................. 344 344
Cash dividends
declared............... (2,900) (2,900)
------ ------- ------ ------ ------ ---- -------
Balance at December 31,
2000................... 8,223 $54,080 -- (1,074) 30,000 (1) 83,005
====== ======= ====== ====== ====== ==== =======
Six months ended Year ended December
Year ended December 31, 31,
June 30, ----------------- ------------------------
Comprehensive Income 1998 1997 1998 1998 1999 2000
-------------------- ---------- ----------- ----- ---------- ----- -----
(unaudited) (unaudited)
Net income............... $4,259 1,570 2,166 4,855 5,357 5,974
Increase (decrease) in
unrealized gain on
securities available for
sale, net of tax of $15,
24,17, 19,(243), and
179..................... 29 47 33 37 (471) 344
------ ----- ----- ----- ----- -----
Comprehensive income..... $4,288 1,617 2,199 4,892 4,886 6,318
====== ===== ===== ===== ===== =====
See accompanying notes to consolidated financial statements.
F-5
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars and shares in thousands)
Six Months Ended Year Ended
Year Ended December 31, December 31,
June 30, -------------------- ------------------------------
1998 1997 1998 1998 1999 2000
---------- ----------- -------- ---------- -------- --------
(unaudited) (unaudited)
Cash flows from
operating activities:
Net income............ $ 4,259 1,570 2,166 4,855 5,357 5,974
Adjustments to
reconcile net income
to net cash provided
by operating
activities, net of
effect of
acquisition:
Depreciation and
amortization......... 1,195 595 790 1,196 2,267 2,256
Deferred loan fees,
net of
amortization......... (149) (38) (124) (234) (193) (71)
Provision for loan
losses............... 149 71 202 280 408 787
Net decrease
(increase) in loans
held for sale........ (89) 1,280 (1,206) (2,575) 7,029 (1,342)
Deferred Federal
income tax expense
(benefit)............ (3) (43) (144) (121) (53) (271)
Federal Home Loan
Bank stock
dividends............ (130) (62) (78) (147) (156) (153)
Recognition of
compensation related
to ESOP.............. -- -- 55 26 75 75
Net change in accrued
interest receivable,
prepaid expenses and
other assets, and
accrued expenses and
other liabilities.... 2,577 (1,209) 460 1,182 444 (2,670)
-------- ------- -------- -------- -------- --------
Net cash provided by
operating
activities......... 7,809 2,164 2,121 4,462 15,178 4,585
-------- ------- -------- -------- -------- --------
Cash flows from
investing activities,
net of effect of
acquisition:
Loans originated, net
of principal payments
and loan sales....... (21,513) (8,610) (12,417) (25,409) (97,747) (63,248)
Maturities of
investment securities
available for sale... 512 -- 4,069 6,465 8,860 3,329
Maturities of
investment securities
held to maturity..... 10,881 4,752 19,351 25,289 10,005 1,093
Purchase of investment
securities held to
maturity............. (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) (476)
Purchase of premises
and equipment........ (712) (193) (807) (1,142) (2,441) (2,319)
Cash acquired, net of
cash paid for
acquisition.......... 10,573 -- -- 10,573 -- --
-------- ------- -------- -------- -------- --------
Net cash used in
investing
activities......... (25,236) (6,501) (14,178) (32,816) (95,846) (61,621)
-------- ------- -------- -------- -------- --------
Cash flows from
financing activities,
net of effect of
acquisition:
Net increase
(decrease) in
deposits............. 27,215 19,234 3,576 (60,950) 37,964 55,166
Net increase
(decrease) in FHLB
advances............. (192) (890) (11) 687 2,113 20,325
Net increase
(decrease) in other
borrowed funds....... (537) (74) (1,340) (1,814) (9) 992
Net increase
(decrease) in advance
payments by borrowers
for taxes and
insurance............ -- -- 57 2 (101) (12)
Cash dividends paid... (342) -- (831) (1,173) (2,438) (2,863)
Issuance of restricted
stock award and
exercise of stock
options.............. 141 34 726 834 271 200
Proceeds received and
held for stock
conversion........... -- 72,506 -- -- -- --
HFC Stock
repurchased.......... (7,435) (15,952)
Net proceeds from
stock offering....... 63,030 -- -- 63,030 -- --
-------- ------- -------- -------- -------- --------
Net cash provided by
(used in) financing
activities......... 89,315 90,810 2,177 616 30,365 57,856
-------- ------- -------- -------- -------- --------
Net increase
(decrease) in cash
and cash
equivalents........ 71,888 86,473 (9,880) (27,738) (50,303) 820
Cash and cash
equivalents at
beginning of year..... 12,213 12,213 80,828 98,686 70,948 20,645
-------- ------- -------- -------- -------- --------
Cash and cash
equivalents at end of
year.................. $ 84,101 98,686 70,948 70,948 20,645 21,465
======== ======= ======== ======== ======== ========
Supplemental
disclosures of cash
flow information:
Cash payments for:
Interest expense...... $ 11,926 5,821 7,208 13,086 12,631 18,456
Federal income
taxes................ 1,886 621 1,640 2,905 2,883 3,492
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 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 five
branch offices located in Yakima and Kittitas Counties. 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 accounting principles generally accepted in the United States of
America. 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
reporting 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 interests 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.
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.
F-7
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(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. Interest on loans is calculated using the simple interest
method based on the daily balance of the principle amount outstanding and is
credited to income as earned. Discounts and premiums on purchased loans are
amortized using the interest method over the remaining contractual lives,
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 losses inherent in the
portfolio at December 31, 2000.
While management uses available information to recognize losses on loans,
future additions to the allowance 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 loan losses. 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 loans are
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 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 periodically evaluates goodwill for
impairment.
(m) Federal Income Taxes
The Company files a consolidated federal income tax return. Deferred tax
assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts
of existing assets and liabilities and their respective tax bases. Deferred
tax assets and liabilities are measured using enacted tax rates expected to
apply to taxable income in the periods in which those temporary differences
are expected to be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rate is recognized in income in the period that
includes the enactment date.
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%. 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) Stock Based Compensation
The Company measures its employee stock-based compensation arrangements
using the provisions outlined in Accounting Principles Board (APB) Opinion No.
25, Accounting for Stock Issued to Employees, which is an intrinsic value-
based method of recognizing compensation costs. As none of the Company's stock
options have any intrinsic value at grant date, no compensation cost has been
recognized for its stock option plan activity.
(p) 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. In June 2000, the FASB issued SFAS Statement No. 138, "Accounting
for Certain Derivative Instruments and Certain Hedging Activities", an
amendment of FASB Statement No. 133, which makes minor modifications to SFAS
No. 133. 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 Corporation.
The SEC issued Staff Accounting Bulletin No. 101B (SAB 101B). SAB 101B
delays the effective date of Staff Accounting Bulletin No. 101 (SAB 101)
"Revenue Recognition in Financial Statements", to the fourth quarter for
fiscal years beginning between December 15, 1999 and March 16, 2000. SAB 101
provides guidance for revenue recognition and the SEC staff's views on the
application of accounting principles to selected revenue recognition issues.
Management adopted the provisions of SAB 101 in the fourth quarter of 2000 and
the adoption did not have a material impact on our consolidated financial
statements.
In March 2000, the Financial Accounting Standards Board issued
Interpretation No. 44, "Accounting for Certain Transactions involving Stock
Compensation". Interpretation No. 44 clarifies the application of Accounting
Principles Board Opinion No. 25 (APB 25) and became effective July 1, 2000.
Interpretation No. 44 clarifies the definition of "employee" for purposes of
applying APB 25, the criteria for determining whether a plan qualifies as a
noncompensatory plan, the accounting consequence of various modifications to
the terms of a previously fixed stock option or award, and the accounting for
an exchange of stock compensation awards in a business combination. Management
adopted Interpretation No. 44 on July 1, 2000, and it did not have a material
impact on the Company's consolidated financial statements.
F-10
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
In September 2000, The Financial Accounting Standards Board issued SFAS No.
140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities," and replaced SFAS No. 125 of the same title.
This statement revises the standards for accounting for securitizations and
other transfers of financial assets and collateral and requires certain
disclosures, but carries over most of SFAS No. 125's provisions without
reconsideration. This statement is effective for transfers and servicing of
financial assets and extinguishments of liabilities occurring after March 31,
2001 and is effective for recognition and reclassification of collateral and
for disclosures relating to securitization transactions and collateral for
fiscal years ending after December 15, 2000. Management does not expect that
adoption of this statement will have a material effect on the results of
operations or the financial position of the Corporation.
(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 $17.6 million in cash for the common stock of North Pacific
Bancorporation. This acquisition was treated as a purchase for accounting
purposes. Accordingly, under accounting principles generally accepted in the
United States of America, 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 $865 and $1,443 as of December 31, 1999 and December 31, 2000,
respectively.
(b) Washington Independent Bancshares, 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. A summary of revenue and net income previously
presented by the Company and combined with WIB for the year ended June 30,
1998, and the six months ended December 31, 1998 are as follows:
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
F-11
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(3) Loans Receivable and Loans Held for Sale
Loans receivable and loans held for sale consist of the following:
December 31,
-----------------
1999 2000
-------- -------
Commercial loans........................................ $192,088 234,166
Real estate mortgages:
One to four family residential........................ 97,907 107,501
Five or more family residential and commercial real
estate............................................... 94,242 109,560
-------- -------
Total real estate mortgage............................ 192,149 217,061
Real estate construction:
One to four family residential........................ 23,293 27,412
Five or more family residential and commercial real
estate............................................... 7,537 --
-------- -------
Total real estate construction.......................... 30,830 27,412
Consumer.............................................. 4,273 5,466
-------- -------
Subtotal.............................................. 419,340 484,105
Unamortized yield adjustments........................... (1,578) (1,670)
-------- -------
Total loans receivable and loans held for sale........ $417,762 482,435
======== =======
Accrued interest on loans receivable amounted to $2,505 and $3,276 as of
December 31, 1999 and December 31, 2000, respectively. The Company had $1,804
and $1,607 of impaired loans which were nonaccruing as of December 31, 1999
and December 31, 2000, respectively. The weighted average interest rate on
loans was 8.6% and 9.0% for December 31, 1999 and December 31, 2000,
respectively.
Details of certain mortgage banking activities are as follows:
December 31,
------------
1999 2000
------ -----
Loans held for sale at lower of cost or market................... $ 589 1,931
Loans serviced for others........................................ 9,534 7,883
Commitments to sell mortgage loans............................... 1,895 2,831
Commitments to fund mortgage loans (at interest rates
approximating market rates)
Fixed rate..................................................... 540 4,241
Variable or adjustable rate.................................... -- --
Servicing fee income from mortgage loans serviced for others amounted to
$56, $22, $34, and $27 for the year ended June 30, 1998, the six months ended
December 31, 1998, and the years ended December 31, 1999 and December 31,
2000, 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.
F-12
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
As of December 31, 2000, the Company had commitments of $52.1 million in
other commercial lines of credit, $34.6 million in real estate commitments
(both construction and lines of credit), and $7.2 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
Year Ended Six months Dec 31,
June 30, Ended Dec 31, ------------
1998 1998 1999 2000
---------- ------------- ----- -----
Balance at beginning of period....... $3,105 3,929 3,957 4,264
Provision.......................... 149 202 408 787
Recoveries......................... 8 13 146 52
Charge offs........................ (3) (187) (247) (40)
Acquired with North Pacific Bank... 670 -- -- --
------ ----- ----- -----
Balance at end of period............. $3,929 3,957 4,264 5,063
====== ===== ===== =====
Interest on nonaccrual loans foregone was $11, $60, and $130 for the six
months ended December 31, 1998, and the years ended December 31, 1999, and
December 31, 2000. Foregone interest was immaterial for the year ended June
30, 1998.
(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, 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
-------- --- ---- ------
$ 36,903 185 (710) 36,378
======== === ==== ======
December 31, 2000
U.S. Government and its agencies.... $ 30,796 19 (126) 30,689
Mortgage backed and related
securities:
Collateralized mortgage
obligations...................... 1,377 -- (19) 1,358
Other............................. 1,100 127 (4) 1,223
Corporate notes..................... 500 1 -- 501
-------- --- ---- ------
Totals.......................... $ 33,773 147 (149) 33,771
======== === ==== ======
F-13
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The amortized cost and fair value of securities available for sale, by
contractual maturity, at December 31, 2000 are shown below:
Amortized Fair
cost value
--------- ------
Due in one year or less.................................. $17,006 16,938
Due after one year through three years................... 12,896 12,845
Due after three through five years....................... 2,393 2,402
Due after five years through ten years................... 295 293
Due after ten years...................................... 1,183 1,293
------- ------
Totals................................................... $33,773 33,771
======= ======
There were no sales of investment securities available for sale during the
year ended June 30, 1998, the six months ended December 31, 1998 or the years
ended December 31, 1999, and December 31, 2000.
Accrued interest on investment securities available for sale amounted to
$385 and $380 as of December 31, 1999 and December 31, 2000, respectively.
At December 31, 1999 and December 31, 2000, investment securities available
for sale with fair values of $14,608 and $18,859 were pledged to secure public
deposits and for other purposes as required or permitted by law.
(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, 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
======= === === =====
December 31, 2000
U.S. Government and its agencies...... $ 900 -- (1) 899
Mortgage backed securities:
FNMA certificates................... 318 9 -- 327
FHLMC certificates.................. 437 13 -- 450
GNMA certificates................... 1,211 68 -- 1,279
Municipal bonds....................... 2,210 14 (5) 2,219
------- --- --- -----
$ 5,076 104 (6) 5,174
======= === === =====
F-14
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The amortized cost and fair value of investment securities held to maturity,
by contractual maturity, at December 31, 2000 are shown below:
Amortized Fair
cost value
--------- -----
Due in one year or less................................... $1,290 1,289
Due after one year through three years.................... 627 627
Due after three years through five years.................. 807 812
Due after five years through ten years.................... 714 728
Due after ten years....................................... 1,638 1,718
------ -----
Totals.................................................... $5,076 5,174
====== =====
There were no sales of investment securities held to maturity during the
years ended June 30, 1998, the six months ended December 31, 1998, or for the
years ended December 31, 1999, and December 31, 2000.
Accrued interest on investment securities held to maturity amounted to $33
and $34 as of December 31, 1999 and December 31, 2000, respectively.
At December 31, 1999 and December 31, 2000, investment securities held to
maturity with amortized cost values of $700 and $820 were pledged to secure
public deposits and for other purposes as required or permitted by law.
(7) Premises and Equipment
A summary of premises and equipment follows:
December 31,
--------------
1999 2000
------- ------
Land....................................................... $ 4,518 4,519
Buildings and building improvements........................ 15,034 16,628
Furniture, fixtures and equipment.......................... 11,204 11,207
------- ------
30,756 32,354
Less accumulated depreciation.............................. 11,882 12,844
------- ------
$18,874 19,510
======= ======
(8) Deposits
Deposits consist of the following:
December 31,
---------------------------------
1999 2000
---------------- ----------------
Amount Percent Amount Percent
-------- ------- -------- -------
Non interest demand deposits............ $ 42,639 10.5% $ 51,298 11.1%
NOW accounts............................ 51,686 12.8 47,315 10.3
Money market accounts................... 44,239 10.9 59,790 13.0
Savings accounts........................ 66,107 16.3 54,830 11.9
Certificate accounts.................... 200,397 49.5 247,001 53.7
-------- ----- -------- -----
$405,068 100.0% $460,234 100.0%
======== ===== ======== =====
F-15
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The combined weighted average interest rate of deposits was 3.67% and 4.46%
at December 31, 1999 and December 31, 2000, respectively. Accrued interest
payable on deposits was $618 and $890 at December 31, 1999 and December 31,
2000, respectively. Interest expense, by category, is as follows:
Six Months Ended Year Ended
Year Ended December 31, December 31,
June 30, ----------------- -------------------------
1998 1997 1998 1998 1999 2000
---------- ----------- ----- ---------- ------ ------
(unaudited) (unaudited)
NOW accounts............ $ 666 325 435 776 767 990
Money market accounts... 2,077 1,035 1,367 2,409 2,872 2,972
Savings accounts........ 511 244 476 743 1,098 1,050
Certificate accounts.... 8,556 4,196 4,861 9,221 8,271 13,618
------- ----- ----- ------ ------ ------
$11,810 5,800 7,139 13,149 13,008 18,630
======= ===== ===== ====== ====== ======
Scheduled maturities of certificate accounts at December 31, 2000 are as
follows:
Within one year $241,350
Between one and two years........................................ 3,637
Between two and three years...................................... 1,455
Between three and four years..................................... 365
Between four and five years...................................... 194
--------
$247,001
========
Certificates of deposit issued in denominations equal to or in excess of
$100,000 totaled $76,958 and $96,069 at December 31, 1999 and December 31,
2000.
(9) FHLB Advances and Stock
The Company 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, 2000, the Company was required to maintain an investment in the stock of
the FHLB of Seattle of at least $1.2 million. Purchases and sales of stock are
made directly with the FHLB at par value.
A summary of FHLB Advances follows:
December 31,
---------------
1999 2000
------ -------
Balance at period end.................................... $2,800 $23,125
Average balance.......................................... 958 10,451
Maximum amount outstanding at any month end.............. 3,300 23,125
Average interest rate:
During the period...................................... 5.90% 6.58%
At period end.......................................... 5.70% 6.81%
At December 31, 2000 the Company had overnight advances of $7,125 at 6.81%
from the FHLB.
F-16
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
FHLB advances that have fixed interest rates are scheduled to mature as
follows:
At December 31,
----------------
1999 2000
------- --------
Note payable, interest only payable month at 6.52%,
maturing on January 19, 2001.......................... -- 5,000
Note payable, interest only payable month at 6.40%,
maturing on January 24, 2001.......................... -- 5,000
Note payable, interest only payable month at 6.45%,
maturing on March 21, 2001............................ -- 1,000
Note payable, interest only payable month at 5.88%,
maturing on December 24, 2001......................... -- 5,000
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.
Heritage Bank and Central Valley Bank may borrow from the FHLB in amounts up
to 20% and 10% of their total assets, respectively.
(10) Federal Funds Purchased
The maximum and average outstanding balances and average interest rates on
fed funds purchased were as follows:
Year Ended Year Ended
December 31, December 31,
1999 2000
------------ ------------
Maximum outstanding at any month-end............ $ -- $1,300
Average outstanding............................. 20 501
Weighted average interest rate:
For the period................................ 5.407% 6.835%
End of period................................. -- 7.125%
Central Valley Bank maintains a federal funds line with Key Bank for $3,600.
This line is renewed annually, and currently matures April 1, 2001. As of
December 31, 2000 the balance of overnight federal funds purchased was $1,000.
(11) Federal Income Taxes
Federal income tax expense (benefit) consists of the following:
Years Ended
Six Months December
Year Ended Ended 31,
June 30, December 31, ------------
1998 1998 1999 2000
---------- ------------ ----- -----
Current................................ $ 2,276 1,419 3,011 3,218
Deferred............................... (3) (144) (53) (271)
------- ----- ----- -----
$ 2,273 1,275 2,958 2,947
======= ===== ===== =====
F-17
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Federal income tax expense differs from that computed by applying the
Federal statutory income tax rate of 34% as follows:
Year Six Months Year Ended
Ended Ended December 31,
June 30, December 31, --------------
1998 1998 1999 2000
-------- ------------ ------ ------
Income tax expense at Federal
statutory rate..................... $ 2,221 1,170 2,827 3,033
Goodwill amortization tax effect.... -- 98 199 196
Other, net.......................... 52 7 (68) (282)
------- ----- ------ ------
$ 2,273 1,275 2,958 2,947
======= ===== ====== ======
The following table presents major components of the deferred Federal income
tax liability resulting from differences between financial reporting and tax
bases.
December 31,
---------------
1999 2000
------- ------
Deferred tax assets:
Loan loss allowances...................................... $ (821) (1,224)
Management bonus.......................................... (153) (68)
Vacation benefits......................................... (94) (101)
Unrealized losses on securities available for sale........ (178) --
Other..................................................... (85) (92)
------- ------
Total deferred tax assets............................... (1,331) (1,485)
Deferred tax liabilities:
Deferred loan fees........................................ 671 700
Premises and equipment.................................... 1,041 975
FHLB stock................................................ 478 576
------- ------
Total deferred tax liabilities.......................... 2,190 2,251
------- ------
Deferred taxes payable, net............................. $ 859 766
======= ======
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.
F-18
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
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.
On April 26, 1999 the board of directors of the Company authorized the
repurchase in the open market of 100,000 of its outstanding common shares.
This was accomplished in the second quarter of 1999 for $0.8 million, or $8.56
per share. In October of 1999, the Company began the first of three stock
repurchase programs. The first totaling 1,082,389 shares, or 10% of the then
outstanding shares was commenced in October 1999 and completed in February
2000. The second totaling 976,748 shares, or 10% of the then outstanding
shares was commenced in February 2000 and completed in August 2000. The third
program for a total of 890,000 shares representing 10% of the then outstanding
shares was commenced in August 2000 of which 611,232 shares were repurchased
as of December 31, 2000. Collectively as of December 31, 2000, the company has
repurchased 2,673,467 shares of stock representing 24% of the total
outstanding as of September 30, 1999 at an average price of $8.63.
(b) Earnings Per Common Share
The following table illustrates the reconciliation of weighted average
shares used for earnings per share computations:
Six Months Ended
Year Ended December 31, Year Ended December 31,
June 30, ---------------------- --------------------------------
1998 1997 1998 1998 1999 2000
---------- ----------- ---------- ----------- ---------- ---------
(unaudited) (unaudited)
Basic:
Weighted average
shares............... 10,394,415 10,235,550 10,553,279 10,663,238 10,763,066 9,098,604
Diluted:
Basic weighted average
shares outstanding... 10,394,415 10,235,550 10,553,279 10,663,238 10,763,066 9,098,604
Incremental shares
from stock options... 275,291 18,337 476,318 396,677 172,331 140,284
---------- ---------- ---------- ---------- ---------- ---------
Weighted average
shares outstanding... 10,669,706 10,253,887 11,029,597 11,059,915 10,935,397 9,238,888
========== ========== ========== ========== ========== =========
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, 96,150 shares and 72,600 shares of common stock
outstanding at December 31, 1998, December 31, 1999 and December 31, 2000,
respectively, whose share price were greater than the market
F-19
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
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.
(c) Cash Dividend Declared
On December 22, 2000, the Company announced a quarterly cash dividend of 9
cents per share payable on January 31, 2001, to shareholders of record on
January 19, 2001.
(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.
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 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, Heritage Bank
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.
At 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
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, Heritage Bank and
Central Valley Bank are 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. As of
December 31, 1999 and December 31, 2000, 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-20
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Well-
Minimum capitalized
Requirements Requirements Actual
--------------------------- -------------
$ % $ % $ %
-------- -------------- --- -------- ----
As of December 31, 2000:
The Company consolidated
Tier 1 leverage capital to
average assets................. $ 16,205 3% $ 27,008 5% $ 75,788 14.0%
Tier 1 capital to risk-weighted
assets......................... 18,955 4 28,433 6 75,788 16.0
Total capital to risk-weighted
assets......................... 37,911 8 47,389 10 80,851 17.1
Heritage Bank
Tier leverage capital to average
assets......................... 14,542 3 24,236 5 67,711 14.0
Tier 1 capital to risk-weighted
assets......................... 16,674 4 25,010 6 67,711 16.2
Total capital to risk-weighted
assets......................... 33,347 8 41,684 10 72,291 17.3
Central Valley Bank
Tier leverage capital to average
assets......................... 2,131 3 3,552 5 5,843 8.2
Tier 1 capital to risk-weighted
assets......................... 2,261 4 3,391 6 5,843 10.3
Total capital to risk-weighted
assets......................... 4,521 8 5,652 10 6,325 11.2
Well-
Minimum 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
(14) Stock Option Plans
In September 1994, Heritage Bank's stockholders approved the adoption of the
1994 stock option plan, providing for the award of a restricted stock award to
a key officer, incentive stock options to employees and nonqualified stock
options to directors of the Bank at the discretion of the Board of Directors.
On September 24, 1996, Heritage Bank's stockholders approved the adoption of
the 1997 stock option plan which is generally similar to the 1994 plan. On
October 15, 1998, the Company's stockholders approved the adoption of the 1998
stock option plan which is similar to the 1994 and 1997 plans. The 1998 plan
does not affect any options granted under the 1994 or 1997 plans.
F-21
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
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 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 year ended June
30, 1998, the six months ended December 31, 1998, and years ended December 31,
1999 and December 31, 2000. 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.
Exercisable
Outstanding Options Options
---------------------- ----------------
Avg. Avg.
Option Option
Shares Under Option Shares Price Shares Price
------------------- ----------- --------- -------- ------
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......................... 144,900 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............ 501,257 6.06 209,459 4.24
=========== ======== ======== =====
Options granted......................... 123,900 9.23 -- --
Became exercisable...................... -- -- 165,802 6.17
Less: Exercised......................... (41,181) 3.24 (41,181) 2.49
Expired or canceled................... (13,800) 9.37 (1,003) 8.94
----------- -------- -------- -----
Balance at December 31, 2000............ 570,176 $ 6.87 333,077 $5.40
=========== ======== ======== =====
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
F-22
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
during June 1998. However, the officer left the Company's employment in
December 1998, and therefore, the restricted stock award was rescinded.
Financial data pertaining to outstanding stock options at December 31, 2000
were as follows:
Weighted Average
Remaining Contractual
Exercise Price Number of Option Shares Life (in years)
-------------- ----------------------- ---------------------
$ 1.94...................... 12,017 0.6
$ 3.11...................... 32,183 2.0
$ 3.58...................... 195,626 3.6
$ 8.50...................... 7,800 5.8
$11.13...................... 71,400 5.4
$ 9.00...................... 17,850 5.7
$ 8.75...................... 6,900 5.7
$ 8.13...................... 2,100 5.7
$ 8.56...................... 1,200 5.8
$ 8.50...................... 3,900 5.8
$ 8.25...................... 9,000 5.9
$ 8.44...................... 89,000 6.4
$ 7.72...................... 17,250 6.7
$ 7.50...................... 1,500 6.7
$ 7.81...................... 9,600 6.8
$ 8.00...................... 1,200 6.9
$ 9.75...................... 91,650 7.3
------- ---
570,176 5.0
======= ===
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:
Year Six Months Year Ended
Ended Ended December 31,
June 30 December 31, -------------
1998 1998 1999 2000
------- ------------ ------ ------
Net income:
As reported......................... $4,259 $2,166 $5,357 $5,974
Pro forma........................... 4,194 2,123 5,176 5,709
Earnings per common share:
Basic:
As reported......................... 0.41 0.20 0.50 0.66
Pro forma........................... 0.40 0.20 0.48 0.63
Diluted:
As reported......................... 0.40 0.20 0.49 0.65
Pro forma........................... 0.39 0.19 0.47 0.62
F-23
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
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 during the year ended June 30, 1998, six
months ended December 31, 1998, and years ended December 31, 1999 and December
31, 2000 is estimated on the date of grant using the Black-Scholes options
pricing model. The following assumptions were used to calculate the fair value
of the options granted:
Risk
Free Expected Weighted
Interest Expected Life Expected Dividend Average
Grant period ended Rate (in years) Volatility Yield Fair Value
------------------ -------- ------------- ---------- -------- ----------
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
December 31, 2000..... 5.16% 7 32% 4.21% 2.41
(15) Employee Benefit Plans
Effective October 1, 1999 the Company combined 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 $240,
$202, $252, and $257 are included in the consolidated statements of income for
the year ended June 30, 1998, the six months ended December 31, 1998, and the
years ended December 31, 1999, and December 31, 2000, 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 year ended June 30, 1998, the six months
ended December 31, 1998, and the years ended December 31, 1999, and December
31, 2000 were $130, $98, $148, and $161, 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. Prior to the January 8,
1998 stock offering, the ESOP owned the common stock of Heritage Bank with no
related debt.
F-24
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
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 $95, $65, $126, and $126 for the years ended June 30, 1998, the
six months ended December 31, 1998, and the years ended December 31, 1999 and
December 31, 2000, respectively.
For the year ended December 31, 2000, the Company has allocated or committed
to be released to the ESOP 8,817 earned shares and has 106,535 unearned,
restricted shares remaining to be released. The fair value of unearned,
restricted shares held by the ESOP trust was $1,085 at December 31, 2000.
(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-25
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(f) Other Borrowings
Other borrowings consist of overnight Federal Funds purchased and considered
at fair value.
(g) Off-Balance Sheet Financial Instruments
The fair value of off-balance sheet commitments to extend credit is
considered equal to its notional amount of the commitments.
The table below presents the book value amount of the Bank's financial
instruments and their corresponding fair values:
December 31, 1999 December 31, 2000
----------------- -----------------
Book Fair Book Fair
value value value value
-------- -------- -------- --------
Financial Assets
Cash on hand and in banks.............. $ 17,596 $ 17,596 $ 20,187 $ 20,187
Interest bearing deposits.............. 949 949 1,278 1,278
Federal funds sold..................... 2,100 2,100 -- --
Investment securities available for
sale.................................. 36,378 36,378 33,771 33,771
Investment securities held to
maturity.............................. 6,165 6,219 5,076 5,174
FHLB stock............................. 2,218 2,218 2,647 2,647
Loans.................................. 413,498 413,049 477,372 483,295
Financial Liabilities
Deposits:
Savings, money market and demand..... 204,671 204,671 213,233 213,233
Time certificates.................... 200,397 199,719 247,001 248,056
-------- -------- -------- --------
Total deposits..................... $405,068 404,390 460,234 461,289
======== ======== ======== ========
FHLB advances.......................... $ 2,800 2,800 23,125 23,126
Other borrowed funds................... $ 8 8 1,000 1,000
(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-26
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,
----------------
1999 2000
-------- -------
ASSETS
Interest earning deposits..................................... $ 3,405 $ 1,530
Loans receivable--ESOP........................................ 1,232 1,178
Investment in subsidiary banks................................ 91,413 80,754
Other assets.................................................. 470 451
-------- -------
$ 96,520 $83,913
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities................................................... 1,256 908
Total stockholders' equity.................................... 95,264 83,005
-------- -------
$ 96,520 $83,913
======== =======
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Income
Six Months Year Ended
Period Ended Ended December 31,
June 30, December 31, --------------
1998 1998 1999 2000
------------ ------------ ------ ------
Interest income:
Interest income.................... $ 737 $ 309 $ 421 $ 70
ESOP loan.......................... 54 55 106 102
Other income:
Other income....................... -- -- 15 --
Equity in undistributed income of
subsidiaries 3,980 2,480 5,462 6,284
------ ------ ------ ------
Total income..................... $4,771 $2,844 $6,004 $6,456
Interest expense..................... 44 7 12 47
Other expenses....................... 300 779 667 595
------ ------ ------ ------
Total expense.................... 344 786 679 642
------ ------ ------ ------
Income before federal income
taxes........................... 4,427 2,058 5,325 5,814
Provision (benefit) for income
taxes............................... 168 (108) (32) (160)
------ ------ ------ ------
Net income......................... $4,259 2,166 5,357 5,974
====== ====== ====== ======
Basic earnings per common share...... $ 0.41 0.20 0.50 0.66
Diluted earnings per common share.... $ 0.40 0.20 0.49 0.65
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 Cash Flows
Six Months Year Ended
Period Ended Ended December 31,
June 30, December 31, ---------------
1998 1998 1999 2000
------------ ------------ ------ -------
Cash flows from operating
activities:
Net income........................ $ 4,259 2,166 5,357 5,974
Adjustments to reconcile net
income to net cash provided by
(used in) operating activities:
Undistributed income of
subsidiaries................... (3,980) (2,480) (5,462) (6,284)
Dividends from subsidiaries..... -- -- 2,150 16,600
Recognition of compensation
related to ESOP................ -- 57 75 75
Other........................... 12 7 97 (19)
Net change in accrued interest
receivable, prepaid expenses
and other assets, and accrued
expenses and other
liabilities.................... (1,097) 129 (662) 275
-------- ------ ------ -------
Net cash provided by (used in)
operations................... (806) (121) 1,555 16,621
Cash flows from investing
activities:
ESOP loan net of principal
repayments....................... (1,304) 23 49 54
Sales (Purchase) of Premises &
Equipment........................ (203) (401) (16) (1)
Purchase of North Pacific Bank.... (17,608) -- -- --
-------- ------ ------ -------
Net cash provided by (used in)
investing activities......... (19,115) (378) 33 53
Cash flows from financing
activities:
Net (increase) decrease in
borrowed funds................... (24) (202) 19 --
Cash dividends paid............... (351) (831) (2,438) (2,863)
Exercise of stock options......... 141 726 271 200
Proceeds from Stock Sale (Stock
repurchase)...................... 32,435 -- (7,439) (15,952)
-------- ------ ------ -------
Net cash provided by financing
activities................... 32,201 (307) (9,587) (18,615)
-------- ------ ------ -------
Net increase (decrease) in
cash and cash equivalents.... 12,280 (806) (7,999) (1,941)
Cash and cash equivalents at
beginning of period................ 6 12,286 11,480 3,481
-------- ------ ------ -------
Cash and cash equivalents at end of
period............................. $ 12,286 11,480 3,481 1,540
======== ====== ====== =======
F-28
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, 2000
-------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
Interest income................................ $10,289 10,878 11,298 11,777
Interest expense............................... 3,997 4,666 5,165 5,573
------- ------ ------ ------
Net interest income.......................... 6,292 6,212 6,133 6,204
Provision for loan losses...................... 195 195 195 202
------- ------ ------ ------
Net interest income after provision for loan
losses...................................... 6,097 6,017 5,938 6,002
Non-interest income............................ 880 1,074 1,149 1,086
Non-interest expense........................... 4,813 4,909 4,825 4,775
------- ------ ------ ------
Income before provision for income taxes..... 2,164 2,182 2,262 2,313
Provision for income taxes..................... 704 709 756 778
------- ------ ------ ------
Net income................................. $ 1,460 1,473 1,506 1,535
======= ====== ====== ======
Basic earnings per share....................... $ 0.15 0.16 0.17 0.18
Diluted earnings per share..................... 0.14 0.16 0.17 0.18
Cash dividends declared........................ 0.075 0.080 0.085 0.090
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 0.060 0.065 0.070
F-29