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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
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FORM 10-K
[_]Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
[X]Transition Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the transition period from June 30, 1998 to December 31, 1998.
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)
----------------
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 $84,158,016 and is based upon the last sales price as quoted on
the NASDAQ Stock Market for March 22, 1999.
The Registrant had 10,976,540 shares of common stock outstanding as of March
22, 1999.
DOCUMENTS TO BE INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement dated March 31, 1999
for the 1999 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, 1998
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................. 14
SUPERVISION AND REGULATION.................................... 17
COMPETITION................................................... 20
EMPLOYEES..................................................... 21
ITEM 2. PROPERTIES.................................................... 21
ITEM 3. LEGAL PROCEEDINGS............................................. 21
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 21
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS.......................................... 22
ITEM 6. SELECTED FINANCIAL DATA....................................... 23
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.......................... 24
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................... 36
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURES...................... 36
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............ 37
ITEM 11. EXECUTIVE COMPENSATION........................................ 37
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT................................................... 37
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................ 37
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS
ON FORM 8-K.................................................. 38
2
ITEM 1. BUSINESS
General
Heritage Financial Corporation (the "Company") is a bank holding company
incorporated in the State of Washington in August 1997. The Company was
organized for the purpose of acquiring all of the capital stock of Heritage
Bank upon its reorganization from a mutual holding company form of
organization to the stock holding company form of organization (the
"Conversion").
The Company is primarily engaged in the business of planning, directing and
coordinating the business activities of its wholly owned subsidiary, Heritage
Bank (the "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) and for the deposits acquired
from North Pacific Bank, the Bank Insurance Fund (BIF). The Bank conducts
business from its main office in Olympia, Washington and its eleven branch
offices located in Thurston, Pierce and Mason Counties. Effective June 12,
1998, the Company acquired North Pacific Bank, a Washington-chartered
commercial bank, which was merged into the Bank effective November 20, 1998.
The business of Heritage Bank consists primarily of focusing on lending and
deposit relationships with small businesses 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 Washington. HB also makes residential construction loans, income
property loans and consumer loans, primarily second mortgage loans.
On September 28, 1998, the Company entered into a definitive merger
agreement with Washington Independent Bancshares, Inc. (Washington
Independent) whereby the Company would acquire all of the outstanding common
stock of Washington Independent (whose wholly owned subsidiary is Central
Valley Bank, N.A., Toppenish, Washington). Effective on the transaction
closing on March 5, 1999, the Company exchanged 1,058,200 shares of its common
stock for all of the 1,781,449 outstanding shares of Washington Independent
common stock. At March 5, 1999, Central Valley Bank had total assets of $61
million and operated 5 full-service banking offices in Yakima County. This
transaction will be accounted for as a pooling of interests and accordingly,
the Company's historical consolidated financial statements presented in future
reports will be restated to include the accounts and results of operations of
Washington Independent.
Market Areas
The Company offers financial services to meet the needs of the communities
it serves through community-oriented financial institutions. Headquartered in
Olympia, Thurston County, Washington, the Company conducts business from
twelve full service offices, six in Pierce County, five in Thurston County and
one in Mason County. The Company has two mortgage origination offices, one in
Thurston and one in Pierce County, both of which operate within banking
offices.
Olympia enjoys a stable economic climate, largely due to government
employment and military personnel, both retired and active. State government
is by far the largest employer in Thurston County, employing over 40% of the
total county work force. Federal, county and municipal government comprise
nearly 50% of the county's employment base. Fort Lewis and McChord Air Force
Base are both located in the Company's primary market area.
Thurston County has a population of 199,700 as of April 1, 1998 and was one
of the fastest growing metropolitan counties in the state of Washington as
reported in the national 1990 census. Thurston County's growth has been
spurred by an increase in government employment in the 1980's and the
expansion of a large retirement population, including many former military
personnel.
Pierce County, where Tacoma is located, has a population of 686,800 as of
April 1, 1998. Its economy is well-diversified, with the principal industry
being aerospace, shipping, military-related government employment,
3
agriculture and forest products. The Puget Sound Economic Forecaster, a
regional publication providing economic forecasts and commentary, predicts
that Pierce County will likely have the strongest economic performance in the
Puget Sound region through 1999. Forbes magazine recently published its
prediction that the Tacoma area would be among the top twenty-five cities in
the United States in terms of job growth, especially in the areas of computers
and semiconductors.
The Company's market area also includes Shelton and the surrounding Mason
County area. The population of Mason county is approximately 49,500 as of
April 1, 1998, and its economy is substantially dependent upon timber and the
forest products industries.
Lending Activities
General. The Company's principal lending activities are carried on through
the Bank. The Company traditionally has originated one- to four-family
residential mortgage loans and, to a lesser extent, multifamily, commercial
real estate and construction loans. In fiscal 1994, the Company implemented a
growth strategy which is intended to broaden its products and services from
traditional thrift products and services to those more closely related to
commercial banking. In this regard, in 1993, the Company began to emphasize
relationship banking, in order to improve customer loyalty through maximizing
the number of lending and deposit relationships with a customer. This strategy
also included expanding the Company's commercial business lending
capabilities. In early fiscal 1997, several commercial loan officers,
experienced in the Puget Sound region, were hired to continue the expansion.
The loan officers, in addition to bringing to the Company some previous
customer relationships, have taken advantage of the opportunity to attract
customers of banks that have been acquired in the recent wave of mergers with
out-of-area acquirers. In June 1998, the Company completed its acquisition of
North Pacific Bank, a $104 million asset commercial bank, which accelerated
the Company's expansion of its commercial banking focus. These efforts
contributed to an increase in commercial loans to $111.8 million, or 38.7% of
total loans, as of December 31, 1998 from $39.4 million, or 18.9% of total
loans, as of June 30, 1997. As the Company pursues its strategy, management is
continuing to emphasize strong asset quality.
The Company's overall lending operations are guided by loan policies which
are reviewed and approved annually by its Board of Directors, and which
outline the basic policies and procedures by which lending operations are
conducted. Generally, the policies address the types of loans, underwriting
and collateral requirements, terms, interest rate and yield considerations,
and compliance with laws and regulations. The Company supplements its 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.
Residential mortgage loans to be placed in the Company's loan portfolio are
approved or denied by a loan committee consisting of senior loan officers and
the Chief Executive Officer. Loan requests for less than $3.5 million and
where the borrower's total bank liability is less then $3.5 million may be
approved by the Chief Executive Officer. Loan requests for over $3.5 million
or any request where the borrower's total bank liabilities exceeds $3.5
million must be approved by the Chief Executive Officer and either the Board
of Directors or the Board's Executive Committee.
4
The following table sets forth at the dates indicated the Company's 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,
1995 1996 1997 1998 1998
---------------- ---------------- ---------------- ---------------- ----------------
% of % of % of % of % of
Balance Total Balance Total Balance Total Balance Total Balance Total
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
(Dollars in thousands)
Commercial.............. $ 9,983 6.31% $ 18,269 10.82% $ 39,445 18.95% $100,489 36.44% $111,817 38.72%
Real Estate Mortgages
One-four family
residential(1)........ 90,985 57.52 93,157 55.15 103,439 49.68 97,598 35.39 93,442 32.36
Five or more family
residential and
commercial
properties............ 38,494 24.33 42,560 25.20 51,209 24.60 57,158 20.73 55,121 19.09
Total real estate
mortgages............. 129,479 81.85 135,717 80.35 154,648 74.28 154,756 56.12 148,563 51.45
Real estate construction
One to four family
residential........... 16,504 10.43 14,509 8.59 12,683 6.09 18,192 6.60 24,922 8.63
Five or more family
residential and
commercial
properties............ 1,538 0.97 393 0.23 1,029 0.49 527 0.19 2,124 .74
Total real estate
construction(2)....... 18,042 11.41 14,902 8.82 13,712 6.59 18,719 6.79 27,046 9.37
Consumer................ 1,812 1.15 1,105 0.65 1,467 0.70 3,030 1.10 2,717 .94
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Total loans............ 159,316 100.71% 169,993 100.65% 209,272 100.52% 276,994 100.45% 290,143 100.48%
Less deferred loan fees
and other.............. (1,126) -0.71 (1,090) -0.65 (1,079) -0.52 (1.228) -0.45 (1,400) -0.48%
-------- ------ -------- ------ -------- ------ -------- ------ -------- ------
Net loans.............. $158,190 100.00% $168,903 100.00% $208,193 100.00% $275,766 100.00% $288,743 100.00%
======== ====== ======== ====== ======== ====== ======== ====== ======== ======
- --------
(1) Includes loans held for sale of $5,944, $5,286, $6,323, $6,411, and
$7,618, respectively.
(2) Balances are net of undisbursed loan proceeds.
The following table presents at December 31, 1998, (i) the aggregate
maturities of loans in the named categories of the Company's 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................................. $34,163 $25,139 $52,515 $111,817
Real estate construction................... 20,418 6,628 -- 27,046
------- ------- ------- --------
Total.................................... $54,581 $31,767 $52,515 $138,863
======= ======= ======= ========
Fixed rate loans........................... $15,972 $16,660 $ 32,632
Variable or adjustable rate loans.......... 15,795 35,855 51,650
------- ------- --------
Total.................................... $31,767 $52,515 $ 84,282
======= ======= ========
Real Estate Lending
One- to Four-Family Residential Real Estate Lending. The majority of the
Company's residential loans are secured by one- to four-family residences
located in the Company's primary market area. The Company's 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. The Company
offers both fixed-rate mortgages and adjustable rate mortgages("ARMs"), with
repricing based on a Treasury Bill or other index. The Company's ability to
generate volume in ARMs however, is largely a function of consumer preference
and the interest rate environment. The Company's current policy is not to make
ARMs with discounted initial interest rates (i.e., "teasers"). The Company
generally sells all government guaranteed mortgages, both fixed rate and
adjustable rate. In addition, in connection with management's strategies to
control the Company's interest rate sensitivity position, management
determines from time to time to what extent it will
5
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. The Company has made, and
anticipates continuing to make, on a selective basis, multifamily and
commercial real estate loans in its primary market areas. Commercial real
estate loans are made for small shopping centers, warehouses and professional
offices, generally owner occupied. Cash flow coverage to debt servicing
requirements is generally 1.2 times or more. The Company's 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 the Bank 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 such loans
may be affected by adverse conditions in the real estate market or the
economy. The Company seeks 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. The Company also generally
obtains personal guarantees from financially capable borrowers based on a
review of personal financial statements.
Construction Loans. The Company originates one- to four-family residential
construction loans for the construction of custom homes (where the home buyer
is the borrower) and provides financing to builders for the construction of
pre-sold homes and speculative residential construction. The Company loans 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. The Company further endeavors to limit its 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. The Company's underwriting standards require that the loan-
to-value ratio for pre-sold homes and speculative residential construction not
exceed 80% of appraised value or builder's cost less overhead, whichever is
less. Speculative construction and land development loans are generally priced
with a variable rate of interest using the prime rate as the index. The
Company generally requires builders to have some tangible form of equity in
each construction project. That objective may be achieved by restricting draws
to less than the acquisition cost of land plus a percentage of the builder's
costs less overhead incurred to date, requiring the loan fees be paid from
outside funds, requiring the builder to place equity funds in a construction
loan account or by not reimbursing fees incurred by the builder such as legal
fees, architectural fees, and building permits. Also, the Company generally
requires prompt and thorough documentation of all draw requests and utilizes
outside inspectors to inspect the project prior to paying any draw requests
from builders.
Construction lending affords the Company the opportunity to achieve higher
interest rates and fees with shorter terms to maturity than does its 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. The nature of these loans is such that they are generally more
difficult to evaluate and monitor. If the estimate of construction cost proves
to be inaccurate, the Company 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, the Company 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 that the construction loan is due.
6
Commercial Business Lending
The Company offers commercial loans to sole proprietorships, partnerships
and corporations with an emphasis on real estate related industries and firms
in the 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 Association
("SBA") loans and unsecured business loans. All unsecured loans in excess of
$750,000 require approval of the Board of Directors.
Commercial business lending generally involves greater risk than residential
mortgage lending and risks that are different from those associated with
residential and commercial real estate lending. Real estate lending is
generally considered to be collateral based lending with loan amounts based on
predetermined loan to collateral values, and liquidation of the underlying
real estate collateral is viewed as the primary source of repayment in the
event of borrower default. Although the Company's 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, 1998, the Company had $111.8 million, or 38.7% of the
Company's total loans receivable, in commercial business loans. Collateral for
these loans is generally owner occupied business or residential real estate.
The average loan size is approximately $200,000 with loans generally in
amounts of $500,000 or less. The Company generally limits its exposure to any
one borrowing relationship to around $4 million; however, there are a few
lending relationships in excess of $4 million with the largest having
approximately $6.0 million in loan commitments.
Origination and Sales of Loans
The Company originates real estate and other loans with approximately two-
thirds of the residential mortgage volumes generated from its two mortgage
loan origination offices. Walk-in customers and referrals from real estate
brokers are important sources of loan originations.
Consistent with the Company's asset/liability management strategy, the
Company sells a majority of its fixed rate and ARM residential mortgage loans
into the secondary market. 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 the Company is only obligated to
sell the mortgage if the mortgage loan is approved and closed by the Company.
When the Company sells mortgage loans, it typically also sells the servicing
of the loans (i.e., collection of principal and interest payments). The
Company serviced $25.6 million and $18.8 million in loans for others as of
June 30, 1998 and December 31, 1998, respectively. The Company received fee
income of $60,000 and $79,000 for the year ended June 30, 1998 and during the
six months ended December 31, 1998 for these servicing activities.
The following table presents summary information concerning the Company's
origination and sale of residential mortgage loans and the gains achieved on
such activities.
Six Months
Year ended June 30, ended
-------------------------- December 31,
1996 1997 1998 1998
-------- -------- -------- ------------
(Dollars in thousands)
One- to four-family residential
mortgage loans:
Originated...................... $140,232 $104,145 $118,774 $68,434
Sold............................ 119,544 87,003 101,903 57,490
Gains on sales of loans, net...... $ 3,049 $ 2,006 $ 2,406 $ 1,297
7
The Company has a minimal amount of purchased loans and loan participations.
Commitments and Contingent Liabilities
In the ordinary course of business, the Company enters into various types of
transactions that include commitments to extend credit that are not included
in the Consolidated Financial Statements. The Company applies the same credit
standards to these commitments as it uses in all its lending activities and
has included these commitments in its lending risk evaluations. The Company's
exposure to credit loss under commitments to extend credit is represented by
the amount of these commitments. At December 31, 1998, the Company had
outstanding commitments to extend credit, including letters of credit, in the
amount of $44.7 million.
Delinquencies and Nonperforming Assets
Delinquency Procedures. When a borrower fails to make a required payment on
a loan, the Company attempts to cause the delinquency to be cured by
contacting the borrower. In the case of loans other than commercial business
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 its review, the Company 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 the Company may bid on the property
to protect its interest. A decision as to whether and when to initiate
foreclosure proceedings is made by the loan committee and is based on such
factors as the amount of the outstanding loan in relation to the value of the
property securing the original indebtedness, the extent of the delinquency,
and the borrower's ability and willingness to cooperate in curing the
delinquency.
Real estate acquired by the Company by deed in lieu of foreclosure is
classified as real estate owned ("REO") until it is sold. When property is
acquired, it is recorded at the lower of cost or estimated fair value at the
date of acquisition, not to exceed net realizable value, and any write-down
resulting therefrom is charged to the allowance for loan losses. Upon
acquisition, all costs incurred in maintaining the property are expensed.
Costs relating to the development and improvement of the property, however,
are capitalized to the extent of the property's net realizable value.
The Company considers 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, the Company may negotiate and accept a modified payment program or take
such other actions as the circumstances warrant.
Classification of Assets. Federal regulations require that the Banks
classify assets on a regular basis. In addition, in connection with
examinations of each Bank, the Division 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
8
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. Assets classified as Substandard
or Doubtful require the institution to establish prudent general allowances
for loan losses. If an asset or portion thereof is classified as Loss, the
institution must charge off such amount. The most recent examinations by the
Division were performed in September 1997 on North Pacific Bank and in March
1998 on Heritage Bank. The regulators' assessment of the Banks' classified
assets is consistent with the Banks' internal classifications.
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 of the Company.
June 30,
--------------------------------- December 31,
1995 1996 1997 1998 1998
------- ------- ------- ------ ------------
(Dollars in thousands)
Nonaccrual loans.............. $ 96 $ 51 $ 133 $ 369 $ 392
Restructured loans............ -- -- -- -- --
------- ------- ------- ------ ------
Total nonperforming loans... 96 51 133 369 392
Real estate owned............. -- -- -- 82 --
------- ------- ------- ------ ------
Total nonperforming assets.. $ 96 $ 51 $ 133 $ 451 $ 392
------- ------- ------- ------ ------
Accruing loans past due 90
days or more................. $ -- $ -- $ -- $ 15 $ 8
Potential problem loans....... 3,718 1,613 68 1,069 212
Allowance for loan losses..... 1,720 1,873 2,752 3,542 3,550
Nonperforming loans to loans.. 0.06% 0.03% 0.06% 0.13% 0.14%
Allowance for loan losses to
loans........................ 1.09% 1.11% 1.32% 1.28% 1.23%
Allowance for loan losses to
nonperforming loans.......... 1791.67% 3672.55% 2069.17% 959.89% 905.61%
Nonperforming assets to total
assets....................... 0.05% 0.02% 0.05% 0.11% 0.10%
Nonaccrual Loans. The Company's financial statements are prepared on the
accrual basis of accounting, including the recognition of interest income on
its 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. The
Company's policy is to place a loan on nonaccrual status when the loan becomes
past due for 90 days or more. Amounts received on nonaccrual loans generally
are applied first to principal and then to interest only after all principal
has been collected.
Interest on nonaccrual loans foregone (recovered) was $0, $990, $5,431, and
$(21,613) for the years ended June 30, 1996, 1997, and 1998 and for the six
months ended December 31, 1998, respectively.
Analysis of Allowance for Loan Losses
The allowance for loan losses is maintained at a level considered adequate
by management to provide for reasonably foreseeable loan losses based on
management's assessment of various factors affecting the loan portfolio,
including a review of problem loans, business conditions and loss experience
and an overall evaluation of the quality of the underlying collateral, holding
and disposal costs and costs of capital. The allowance is increased by
provisions for loan losses charged to operations and reduced by loans charged
off, net of recoveries.
Over the past two years, the Company has increased its allowance for loan
losses during a period of loan growth and change in loan portfolio
composition. While the Company's loan portfolio, and in particular commercial
loans, have grown substantially over the past three years, the Company's asset
quality has remained
9
very solid as demonstrated by the low charge-offs and the low nonperforming
assets to total assets ratio during that period. In the six months ended
December 31, 1998, the Company experienced net charge offs of $172,000, most
of which were related to loans originated and classified by North Pacific Bank
prior to the Company's acquisition of North Pacific Bank in June 1998. Because
commercial business lending generally involves greater risk than those
associated with residential and commercial real estate lending, the Company
has increased the portion of its general allowance for loan losses allocated
to its commercial loans over the past three years.
While management believes that it uses the best information available to
determine the allowance for loan losses, unforeseen market conditions could
result in adjustments to the allowance for loan losses, and net income could
be significantly affected, if circumstances differ substantially from the
assumptions used in determining the allowance.
The following table sets forth for the periods indicated information
regarding changes in the Company's allowance for loan losses:
Six Months
Year Ended June 30, Ended
-------------------------------------- December 31,
1995 1996 1997 1998 1998
-------- -------- -------- -------- ------------
(Dollars in thousands)
Total loans outstanding at
end of period(1)......... $158,190 $168,903 $208,192 $275,766 $288,743
-------- -------- -------- -------- --------
Average loans outstanding
during period............ $144,266 $161,501 $184,617 $213,161 $284,376
-------- -------- -------- -------- --------
Allowance balance at
beginning of period...... $ 1,705 $ 1,720 $ 1,873 $ 2,752 $ 3,542
Provision for loan
losses................... -- -- (270) 120 180
Acquired with North
Pacific Bank............. -- -- -- 670 --
Charge-offs:
Real estate(2).......... -- -- -- -- (36)
Commercial.............. -- -- (3) -- (145)
Consumer................ -- -- -- -- --
-------- -------- -------- -------- --------
Total charge-offs..... -- -- (3) -- (181)
-------- -------- -------- -------- --------
Recoveries:
Real estate(2).......... 15 153 1,152 -- --
Commercial.............. -- -- -- -- 9
Consumer................ -- -- -- -- --
-------- -------- -------- -------- --------
Total recoveries...... 15 153 1,152 -- 9
-------- -------- -------- -------- --------
Net (charge-offs)
recoveries......... 15 153 1,149 -- (172)
-------- -------- -------- -------- --------
Allowance balance at end
of period................ $ 1,720 $ 1,873 $ 2,752 $ 3,542 $ 3,550
======== ======== ======== ======== ========
Ratio of net (charge-offs)
recoveries during
period to average loans
outstanding.............. 0.01% 0.09% 0.62% 0.00% (0.06%)
======== ======== ======== ======== ========
- --------
(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 the Company and
industry wide and other factors which may affect future loan losses in the
categories shown below:
At June 30, At
--------------------------------------------------------------- December 31,
1995 1996 1997 1998 1998
--------------- --------------- --------------- --------------- ---------------
% 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.............. $ 200 6.3% $ 446 10.8% $1,094 18.8% $2,044 36.3% $2,496 38.7%
Real estate mortgages:
One- to four-family
residential........... 115 57.1 110 54.8 128 49.4 124 35.2 115 32.0
Five or more family
residential and
commercial
properties............ 1,136 24.2 959 25.0 748 24.5 524 20.6 509 19.1
Real estate
construction:
One- to four-family
residential........... 182 10.4 239 8.5 197 6.1 201 6.6 117 8.6
Five or more family
residential and
commercial
properties............ 29 0.9 12 0.2 31 0.5 10 0.2 16 0.7
Consumer................ 10 1.1 3 0.7 7 0.7 38 1.1 40 0.9
Unallocated............. 48 103 546 601 257
------ ----- ------ ----- ------ ----- ------ ----- ------ -----
Total.................. $1,720 100.0% $1,873 100.0% $2,752 100.0% $3,542 100.0% $3,550 100.0%
====== ===== ====== ===== ====== ===== ====== ===== ====== =====
- --------
(1) Represents the total of all outstanding loans in each category as a
percent of total loans outstanding.
Investment Activities
At December 31, 1998, the investment securities portfolio totaled $38.9
million, consisting of $25.8 million of securities available for sale and
$13.1 million of securities held to maturity. This compares with a total
portfolio of $38.8 million at June 30, 1998, comprised of $9.0 million of
securities available for sale and $29.7 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.
The investment policies of the Company are established by the Boards 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 the 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, certain certificates of
deposit of insured banks, mortgage backed and mortgage related securities,
certain 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)
June 30, 1998
U.S. Government and its
agencies........................ $ 8,022 $ 6 $-- $ 8,028
Corporate notes.................. 1,013 -- -- 1,013
------- ---- ---- -------
Totals......................... $ 9,035 $ 6 $-- $ 9,041
======= ==== ==== =======
December 31, 1998
U.S. Government and its
agencies........................ $21,093 $ 56 $(47) $21,102
Collateralized mortgage
obligations..................... 2,690 (10) 2,680
Corporate notes and other........ 2,001 9 2,010
------- ---- ---- -------
Totals......................... $25,784 $ 65 $(57) $25,792
======= ==== ==== =======
The Company had no securities available for sale at June 30, 1997. The
Company had no securities available for trading at June 30, 1997 and 1998 and
at December 31, 1998.
The following table sets forth certain information regarding the carrying
value, weighted average yields and maturities or periods to repricing of the
Company's investment securities available for sale at December 31, 1998.
AT DECEMBER 31, 1998
------------------------
WEIGHTED
BOOK FAIR AVERAGE
VALUE VALUE YIELD
------- ------- --------
(DOLLARS IN THOUSANDS)
Obligations of US Government agencies:
Due within one year............................... 3,993 4,028 6.08%
Due after 1 year but within 5 years............... 17,100 17,074 5.42
------- -------
21,093 21,102
------- -------
Corporate notes and other investments:
Due after 1 year but within 5 years............... 501 510 6.73
Due after 5 years but within 10 years............. 500 500 6.29
Due after 10 years................................ 1,000 1,000 5.42
------- -------
2,001 2,010
------- -------
Collateralized mortgage obligations.................
Due after 10 years................................ 2,690 2,680 5.64
------- -------
Total all investments available for sale............ $25,784 $25,792
======= =======
12
The following table summarizes the amortized cost, gross unrealized gains
and losses and the resulting fair value of investment securities held to
maturity:
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- -------
(DOLLARS IN THOUSANDS)
June 30, 1998:
U.S. Government and its agencies.............. $22,996 $ 5 $(22) $22,979
Mortgage backed securities.................... 3,844 247 (8) 4,083
Municipal bonds............................... 2,891 25 (3) 2,913
------- ---- ---- -------
Total held for investment................. 29,731 277 (33) 29,975
======= ==== ==== =======
December 31, 1998:
U.S. Government and its agencies.............. 7,348 10 (3) 7,355
Mortgage backed securities.................... 3,262 86 -- 3,348
Municipal bonds............................... 2,539 76 -- 2,615
------- ---- ---- -------
Total held for investment................. $13,149 $172 $ (3) $13,318
======= ==== ==== =======
The following table sets forth certain information regarding the carrying
value, weighted average yields and maturities or periods to repricing of the
Company's investment securities held to maturity at December 31, 1998.
AT DECEMBER 31, 1998
------------------------
WEIGHTED
BOOK FAIR AVERAGE
VALUE VALUE YIELD(1)
------- ------- --------
(DOLLARS IN THOUSANDS)
Obligations of US Government agencies:
Due within one year............................... 1,700 1,698 5.41%
Due after 1 year but within 5 years............... 5,648 5,657 5.95
------- -------
7,348 7,355
------- -------
Municipal bonds
Due within one year............................... 392 398 7.55
Due after 1 year but within 5 years............... 1,047 1,074 6.76
Due after 5 years but within 10 years............. 1,100 1,143 6.49
------- -------
2,539 2,615
------- -------
Mortgage backed securities
Due after 1 year but within 5 years............... 36 36 7.63
Due after 5 years but within 10 years............. 159 161 8.25
Due after 10 years................................ 3,067 3,151 8.33
------- -------
3,262 3,348
------- -------
Total all investments held to maturity.......... $13,149 $13,318
======= =======
- --------
(1) Tax equivalent weighted average yield.
The Company held $2.1 million of FHLB stock at December 31, 1998. 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, 1998, the Company was
required to maintain an investment in the stock of FHLB of Seattle of at least
$1.4 million.
13
Deposit Activities and Other Sources of Funds
General. The Company's primary sources of funds are customer deposits and
loan repayments. Scheduled loan repayments are a relatively stable source of
funds, while deposit inflows and outflows and unscheduled loan prepayments,
which are influenced significantly by general interest rate levels, interest
rates available on other investments, competition, economic condition and
other factors, are not. Although the Company's deposit balances have been
increasing, such balances have been influenced in the past by adverse changes
in the thrift industry and may be affected by such 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. The Company offers 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, 1998, the Company had no brokered
deposits. The more significant deposit accounts offered by the Company are
described below.
Certificates of Deposit. The Company offers several types of CDs with
maturities ranging from 30 days to five years and which require a minimum
deposit of $100. In addition, the Company offers a CD that has a maturity of
four to 11 months and a minimum deposit of $2,500 and permits additional
deposits at the initial rate throughout the certificate term. Interest is
credited quarterly or at maturity. Finally, jumbo CDs are offered in amounts
of $100,000 or more for terms of 30 days to 12 months. The jumbo CDs pay
simple interest and are credited either quarterly or at maturity.
Regular Savings Accounts. The Company offers 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 contributions of up to $2,000
per year and pay interest at fixed rates. Maturities are available from one to
five years and interest is compounded daily and credited quarterly.
14
Sources of Funds
Deposit Activities. The following table sets forth for the periods indicated
the average balances outstanding and the weighted average interest rates for
each major category of deposits:
Year Ended June 30
-------------------------------------------------------- Six Months Ended
1996 1997 1998 December 31, 1998
------------------ ------------------ ------------------ ------------------
Average Average Average Average
Average Rate Average Rate Average Rate Average Rate
Balance(1) Paid Balance(1) Paid Balance(1) Paid Balance(1) Paid
---------- ------- ---------- ------- ---------- ------- ---------- -------
(Dollars in thousands)
Interest bearing demand
and money market
accounts............... $ 36,930 3.15% $ 42,271 3.18% $ 50,156 3.14% $ 71,484 2.72%
Savings................. 28,407 3.63 29,703 3.55 36,033 3.60 57,675 3.55
Certificates of
deposit................ 109,559 5.78 119,133 5.54 130,591 5.55 153,566 5.46
Total interest bearing
deposits.............. 174,895 4.88 191,107 4.71 216,780 4.67 282,725 4.38
Demand and other
noninterest bearing
deposits............... 6,537 -- 7,955 -- 13,140 -- 22,914 --
-------- ---- -------- ---- -------- ---- -------- ----
Total deposits......... $181,432 4.70% $199,063 4.52% $229,920 4.40% $305,639 4.05%
======== ==== ======== ==== ======== ==== ======== ====
- --------
(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 June 30, Ended
-------------------------- December 31,
1996 1997 1998 1998
------- ------- -------- ------------
(Dollars in thousands)
Net increase (decrease) in
deposits......................... $16,322 $18,662 $104,339 $ (5,309)
Less: Interest credited......... (8,528) (8,999) (10,002) (5,393)
------- ------- -------- --------
Net increase (decrease) before
interest credited................ $ 7,794 $ 9,663 $ 94,337 $(10,702)
======= ======= ======== ========
Of the $104.3 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, 1998:
December 31,
1998
------------
(Dollars in
thousands)
Remaining maturity:
Three months or less...................................... $14,139
Over three months through six months...................... 4,902
Over six months through 12 months......................... 6,256
Over twelve months........................................ 990
-------
Total................................................... $26,287
=======
At June 30, 1998 and December 31, 1998 certificates of deposits with
balances of $100,000 or more totaled $23.0 million and $26.3 million,
respectively.
Borrowings. Savings deposits are the primary source of funds for the
Company's lending and investment activities and for its general business
purposes. The Company relies upon advances from the FHLB of Seattle to
15
supplement its supply of lendable funds and to meet deposit withdrawal
requirements. The FHLB of Seattle has served as one of the Company's secondary
sources of liquidity. Advances from the FHLB of Seattle are typically secured
by the Company's first mortgage loans, and stock issued by the FHLB of
Seattle, which is held by the Company.
The FHLB functions as a central reserve bank providing credit for savings
and loan associations and certain other member financial institutions. As a
member, the Bank is required to own capital stock in the FHLB and is
authorized to apply for advances on the security of such stock and certain of
its mortgage loans and other assets (principally securities which are
obligations of, or guaranteed by, the United States) provided certain
standards related to creditworthiness have been met. 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 short term
borrowings of less than one year may not exceed 10.0% of the institution's
assets. The FHLB of Seattle determines specific lines of credit for each
member institution.
The following table is a summary of FHLB advances for the years ended June
30, 1997 and 1998 and the six months ended December 31, 1998:
At or for At or for
the year ended the six
June 30, months ended
------------------ December 31,
1996 1997 1998 1998
----- ------ ---- ------------
(Dollars in thousands)
Balance at period end..................... $ -- $ 890 $698 $687
Average balance during the period......... -- 27 156 693
Maximum amount outstanding at any month
end...................................... -- 1,300 698 696
Average interest rate
During the period....................... -- 5.47% 5.73% 6.20%
At period end........................... -- 6.45% 6.20% 6.20%
The following table is a summary of other borrowed funds for the year ended
June 30, 1998 and the six months ended December 31, 1998. There were no other
borrowed funds outstanding during the years ended June 30, 1996 and 1997.
At or for
At or for the six months
the year ended ended December
June 30, 1998 31,
-------------- --------------
(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% --
16
Supervision and Regulation
The Company and the Bank 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 shareholders
of the Company. The laws and regulations affecting banks and bank holding
companies have changed significantly over recent years, and there is reason 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 the business, operations and prospects of the Company. The Company is
unable to predict the nature or the extent of the effects on its business and
earnings that any fiscal or monetary policies or new federal or state
legislation may have in the future.
The following information is qualified in its entirety by reference to the
particular statutory and regulatory provisions described herein.
The Company. The Company is subject to regulation as a bank holding company
within the meaning of the Bank Holding Company Act of 1956, as amended, (the
"BHCA"). As such, the Company is 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 BHCA 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. Certain violations may also
result in criminal penalties. The FDIC is authorized to exercise comparable
authority under the Federal Deposit Insurance Act and other statutes with
respect to state nonmember banks such as the Banks.
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 Board'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 Board to be an unsafe and unsound
banking practice or a violation of the Board'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 guarantee by
each company having control of the bank's compliance with the plan.
The BHCA prohibits a bank holding company, with certain exceptions, from
acquiring direct or indirect ownership or control of any company which is not
a bank or from engaging in any activities other than those of banking,
managing or controlling banks and certain other subsidiaries, or furnishing
services to or performing services for its subsidiaries. One principal
exception to these prohibitions allows a bank holding company to acquire an
interest in companies whose activities are found by the Federal Reserve, by
order or by regulation, to be so closely related to banking or managing or
controlling banks as to be a proper incident thereto. The Company must obtain
the approval of the Federal Reserve before it acquires all, or substantially
all, of any bank, or ownership or control of more than 5% of the voting shares
of a bank.
The Company is required under the BHCA to file an annual report and periodic
reports with the Federal Reserve and such additional information as the
Federal Reserve may require pursuant to the BHCA. The Federal Reserve may
examine a bank holding company and any of its subsidiaries and charge the
company for the cost of such an examination.
17
The Company and any subsidiaries which it may control are deemed
"affiliates' within the meaning of the Federal Reserve Act, and transactions
between bank subsidiaries of the company and its affiliates are subject to
certain restrictions. With certain exceptions, the Company and its
subsidiaries are prohibited from tying the provision of certain services, such
as extensions of credit, to other services offered by the Company or its
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 shareholders'
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 certain 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%.
Bank. Heritage Bank is a Washington state-chartered savings bank, the
deposits of which are insured by the FDIC. The Bank is subject to regulation
by the FDIC and the Washington Department of Financial Institutions (the
"Division"). Although the Bank is not a member of the Federal Reserve System,
the Federal Reserve supervisory authority over the Company may also affect the
Bank.
Among other things, applicable federal and state statutes and regulations
which govern a bank's operations relate to minimum capital requirements,
required reserves against deposits, investments, loans, legal lending limits,
mergers and consolidation, borrowings, issuance of securities, payment of
dividends, establishment of branches and other aspects of its operations. The
Division 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 Bank is required to file periodic reports with the FDIC and the Division
and is subject to periodic examinations and evaluations by those regulatory
authorities. Based upon such an evaluation, 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 certain 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 a subsidiary of a bank holding company, the Bank is subject to certain
restrictions in their dealings with the Company and with other companies that
may become affiliated with the Company.
In addition to earnings on the portion of net stock offering proceeds
retained by the Company, dividends paid by the Bank will provide substantially
all of the Company's cash flow. Applicable federal and Washington state
regulations restrict capital distributions by institutions such as the Bank,
including dividends. Such restrictions are tied to the institution's capital
levels after giving effect to such distributions. The FDIC has 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%. The Bank qualified as
"well-capitalized" at December 31, 1998.
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 such deposits.
Adequately capitalized institutions are allowed to solicit such 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
18
Improvement Act of 1991 ("FDICIA"). FIRREA, among other thing, (i) created two
deposit insurance funds administered by the FDIC, the Bank Insurance Fund
("BIF") and the SAIF; (ii) permitted commercial banks that meet certain
housing-related asset requirements to secure advances and other financial
services from local FHLBs; (iii) restructured the federal regulatory agencies
for savings associations; and (iv) 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, (i) a new method
for calculating deposit insurance premiums based on risk, (ii) restrictions on
acceptance of brokered deposits except by well-capitalized institutions, (iii)
additional limitations on loans to executive officers and directors of banks,
(iv) the employment of interest rate risk in the calculation of risk-based
capital, (v) safety and soundness standards that take into consideration,
among other things, management, operations, asset quality, earnings and
compensation, (vi) 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 (vii) 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. Such banks, or their holding companies,
are also required to establish audit committees consisting of directors who
are independent of management.
Also, the Riegle-Neal Interstate Banking and Branching Efficiency Act of
1994 (the "Interstate Banking Act") provides banks with greater opportunities
to merge with other institutions and to open branches nationwide.
The Interstate Banking Act 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.
The Interstate Banking 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".
In addition, the Interstate Banking 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 (i) authorize such transactions at an earlier date or (ii) 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.
Further effects on the Company and the Banks may result from the Riegle
Community Development and Regulatory Improvement Act of 1994 (the "Community
Development Act"). The Community Development Act (i) establishes and funds
institutions that are focused on investing in economically distressed areas
and (ii) streamlines the procedures for certain transactions by financial
institutions with federal banking agencies.
Among other things, the Community Development Act requires the federal
banking agencies to (i) consider the burdens that are imposed on financial
institutions when new regulations are issued or new compliance
19
burdens are created and (ii) coordinate their examinations of financial
institutions when more than one agency is involved. The Community Development
Act also streamlines the procedures for forming certain one-bank holding
companies and engaging in authorized non-banking activities.
The Bank's deposit accounts are insured by the FDIC, primarily under the
SAIF (and under the BIF for deposits acquired through North Pacific Bank) to
the maximum extent permitted by law. The 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
therewith, 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 the 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
obligations issued by the Financing Corporation ("FICO") in the 1980s to help
fund the thrift industry cleanup. BIF-assessable deposits will be charged an
assessment to help pay interest on the FICO 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 provide 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. The recent Act contemplates the development of a common charter
for all federally chartered depository institutions and the abolition of
separate charters for national banks and federal savings associations. It is
not known what form the common charter may take and what effect, if any, the
adoption of a new charter would have on the operation of the Bank.
In addition to the changes to the BIF and SAIF assessment rates implemented
by the recent legislation, various regulatory relief provisions were enacted.
The new legislation, among other things, (i) changes the Truth in Lending Act
and the Real Estate Settlement Procedures Act to coordinate and simplify the
two laws' disclosure requirements; (ii) eliminates civil liability for
violations of the Truth in Savings Act after five years; (iii) streamlines the
application process for a number of bank holding company and bank
applications; (iv) establishes a privilege from discovery in any civil or
administrative proceeding or bank examination for any fair lending self-test
results conducted by, or on behalf of, a financial institution in certain
circumstances; (v) repeals the FDICIA requirement that independent public
accountants attest to compliance with designated safety and soundness
regulations; (vi) imposes a continuous regulatory review of regulations to
identify and eliminate outdated and unnecessary rules; and (vii) includes
various other miscellaneous provisions to reduce bank regulatory burden.
The Company is also subject to the information, proxy solicitation, insider
trading restrictions and other requirements of the Securities Exchange Act of
1934.
Competition
The Company competes 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 these
competitors have substantially
20
greater resources than the Company. Particularly in times of high interest
rates, the Company also faces significant competition for investors' funds
from short term money market securities and other corporate and government
securities.
The Company competes for loans principally through the range and quality of
the services it provides, interest rates and loan fees, and the locations of
its Banks' branches. The Company actively solicits deposit-related clients and
competes for deposits by offering depositors a variety of savings accounts,
checking accounts and other services.
Employees
At December 31, 1998, the Company had 191 full-time equivalent employees.
The Company believes that employees play a vital role in the success of a
service company. None of the Company's employees are covered by a collective
bargaining agreement with the Company and management believes that they have a
good relationship with the employees.
ITEM 2. PROPERTIES
The Company's 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, 1998, the 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).
ITEM 3. LEGAL PROCEEDINGS
The Company and the Banks have certain litigation and negotiations in
progress resulting from activities arising from normal operations. In
management's opinion, none of these matters is likely to have a material
adverse effect on the financial position or results of operations of the
Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
At the Company's Annual Meeting of Stockholders held on October 15, 1998,
the directors nominated for election as described in the Proxy Statement (John
A. Clees, James P. Senna and Peter K. Wallerich) were elected to serve as
members of the Company's Board of Directors until the Annual Meeting of
Stockholders in 2001 by a vote of 8,268,863 in favor and 197,156 votes in
opposition. Directors Donald V. Rhodes, Daryl D. Jensen and H. Edward Odegard
will continue in office until the 1999 Annual Meeting. Directors Lynn M.
Brunton and Philip S. Weigand will continue in office until the 2000 Annual
Meeting.
In addition, the 1998 Stock Option and Restricted Stock Award Plan as
described in the Proxy Statements was voted on at this meeting. The 1998 Stock
Option and Restricted Award Plan provides for the grant of stock options and
stock awards for up to 461,125 shares. The Plan was approved by a vote of
7,690,183 in favor, 647,026 votes in opposition and 128,810 votes abstained.
On October 15, 1998, the Company's Board voted to change the Company's
fiscal year from June 30 to the calendar year ending December 31 effective on
January 1, 1999. The Proxy Statement for the October 15, 1998 annual meeting
of the Company's shareholders indicated that shareholder proposals for the
1999 annual meeting would be due by May 1, 1999. Since the Company's fiscal
year has changed, the Board determined to conduct the Company's 1999 annual
meeting on April 27, 1999---earlier than the originally anticipated October,
1999 annual meeting date. The Board will receive shareholder proposals for
review and, if appropriate, presentation at the April 27, 1999 annual meeting
by April 17, 1999.
21
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's common stock is traded on the NASDAQ National Market under the
symbol HFWA. At December 31, 1998, the Company had approximately 1,412
stockholders of record (not including the number of persons or entities
holding stock in nominee or street name through various brokerage firms) and
9,793,145 outstanding shares of common stock. The last reported sales price on
March 22, 1999 was $8.75 per share. The following table sets forth for the
quarters indicated the range of high and low bid information per share of the
common stock of the Company as reported on the NASDAQ National Market.
Quarter ended:
----------------------------------------
June
March 31 30 September 30 December 31
-------- ------ ------------ -----------
High.............................. $15.50 $16.06 $15.00 $12.38
Low............................... $12.63 $13.50 $ 8.88 $ 9.13
Since its stock offering in January 1998, the Company has 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
Dividends from the Company depend, in part, upon earnings from the
investment of the net proceeds from the Conversion retained by the Company and
receipt of dividends from its subsidiary bank. The FDIC and the Division have
the authority under their supervisory powers to prohibit the payment of
dividends by the Bank to the Company. For a period of ten years after the
Conversion, the Bank may not, without prior approval of the Division, declare
or pay a cash dividend in an amount in excess of one-half of (i) the greater
of the Bank's net income for the current fiscal year or (ii) the average of
the Bank's net income for the current fiscal year and not more than two of the
immediately preceding fiscal years. In addition, the Bank may not declare or
pay a cash dividend on its common stock if the effect thereof would be to
reduce the Bank's net worth below the amount required for the liquidation
account. Other than the specific restrictions mentioned above, current
regulations allow the Company and its subsidiary bank 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.
22
ITEM 6. SELECTED FINANCIAL DATA
For the six
months
For the year ended June 30, ended
------------------------------------------------ December 31,
1994 1995 1996 1997 1998 1998
-------- -------- -------- -------- -------- ------------
(Dollars in thousands, except per share data)
Operations Data:
Net interest income..... $ 6,788 $ 8,227 $ 8,332 $ 9,512 $ 13,013 $ 9,412
Provision for loan
losses................. -- -- -- (270) 120 180
Noninterest income...... 4,019 3,040 4,298 3,347 3,791 2,439
Noninterest expense..... 7,421 7,425 8,422 11,105 11,093 8,629
Provision (benefit) for
income taxes........... 1,154 1,308 1,435 (245) 1,963 1,118
Net income.............. 2,232 2,534 2,773 2,269 3,628 1,924
Earnings per share (1)
Basic................. NA 0.27 0.30 0.24 0.38 0.20
Diluted............... NA 0.27 0.30 0.24 0.37 0.19
Dividend payout ratio
(2).................... NM NM NM NM 19.74% 47.50%
Performance Ratios:
Net interest spread..... 3.45% 4.14% 3.84% 4.06% 3.87% 4.03%
Net interest margin
(3).................... 3.83 4.57 4.31 4.50 4.80 5.07
Efficiency ratio (4).... 68.67 65.90 66.68 77.89 66.01 66.50
Return on average
assets................. 1.18 1.30 1.31 0.99 1.24 0.94
Return on average
equity................. 13.05 11.67 11.38 8.62 6.15 4.06
At June 30,
------------------------------------------------ At
1994 1995 1996 1997 1998 December 31,
-------- -------- -------- -------- -------- ------------
Balance Sheet Data:
Total assets............ $197,102 $204,897 $222,052 $242,164 $415,851 $411,983
Loans receivable, net... 123,258 150,526 161,744 199,188 265,813 277,575
Loans held for sale..... 4,110 5,944 5,286 6,323 6,411 7,618
Deposits................ 165,922 174,797 191,119 209,781 314,120 308,811
Federal Home Loan Bank
advances............... -- -- -- 890 698 687
Other borrowings........ 4,100 3,252 -- -- 1,132 17
Stockholders' equity.... 20,662 23,065 25,633 27,714 93,887 95,433
Book value per share.... NM NM NM NM $ 9.72 $ 9.74
Equity to assets ratio.. 11.64% 11.26% 11.54% 11.44% 22.57% 23.16%
Asset Quality Ratios:
Nonperforming loans to
loans.................. 0.07% 0.06% 0.03% 0.06% 0.13% 0.14%
Allowance for loan
losses to loans........ 1.32 1.09 1.11 1.32 1.28 1.23
Allowance for loan
losses to nonperforming
loans.................. 1,776.04 1,791.67 3,672.55 2,069.17 959.89 905.61
Nonperforming assets to
total assets........... 0.05 0.05 .0.2 0.05 0.11 0.10
Other Data:
Number of banking
offices................ 5 7 8 10 12 12
Number of full-time
equivalent
employees.............. 119 116 136 145 192 191
- --------
(1) The Bank became a stock-owned company as of January 31, 1994. Per share
data prior to 1995 is not applicable.
(2) Dividend payout ratio is declared per share divided by earnings per share.
Cash dividends prior to January 1998 stock offering and conversion are not
comparable to prior periods due to the former mutual holding company's
waiver of its pro rata cash dividends.
(3) Net interest margin is net interest income divided by average interest
earning assets.
(4) The efficiency ratio is recurring noninterest expense divided by the sum
of net interest income and noninterest income, excluding nonrecurring
items. The Bank paid a one-time assessment of $ 1.09 million to the Savings
Association Insurance Fund in November 1996. This amount was excluded from
the calculation of the efficiency ratio for 1997.
23
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,
1998 audited consolidated financial statements and notes thereto included in
this Form 10-K.
Statements concerning future performance, development or events, concerning
expectations for growth and market forecasts, and any other guidance on future
periods, constitute forward-looking statements and 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 condition. Additional information on these and other factors
which could affect the Company's financial results are included in filings by
the Company with the Securities and Exchange Commission.
General
In fiscal 1994, the Company began to implement a growth strategy intended to
broaden its products and services from traditional thrift offerings to those
more closely related to commercial banking. That strategy entails (1)
geographic and product expansion, (2) loan portfolio diversification, (3)
development of relationship banking, and (4) maintenance of asset quality. The
Company has incurred substantial expenses as it carried out its growth
strategy. Those expenses have been concentrated in (i) personnel hired in
anticipation of growth and expanded market share; (ii) maintaining the
mortgage origination capacity during times of fluctuating mortgage origination
volumes; (iii) facilities expansion and (iv) upgrading data processing
capabilities. These expenditures had a negative impact on the Company's
earnings in fiscal 1997, fiscal 1998 and for the six months ended December 31,
1998. Management believes these investments will have a positive impact on
earnings into 1999.
In fiscal 1998, the Company's growth strategy was further bolstered by two
significant events: (1) the January 1998 stock offering and conversion and (2)
its acquisition of North Pacific Bancorporation. Through the January 1998
stock offering, the Company raised $63.0 million in net new capital which has,
and will continue to, enhance its ability to implement its growth strategy.
Using $17.5 million of the net proceeds of the stock offering, the Company
completed its 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. This acquisition of North Pacific Bank
provided further geographical expansion into the Pierce County market area and
enhanced expertise in commercial banking. This is demonstrated by the
substantial shift in loan portfolio composition as commercial loans increased
to $111.8 million, or 38.7% of total loans, as of December 31, 1998 from
$39.4 million, or 18.9% of total loans, as of June 30, 1997. While this
acquisition had a significant impact on the Company's growth and financial
condition at June 30, 1998, North Pacific Bank's operations had a minimal
impact on the Company's earnings for the year ended June 30, 1998 due to the
timing of the closing of the transaction on June 12, 1998. During the six
months ended December 31, 1998, management 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. Management invested $1.1 million in item processing hardware and
software and facilities which became operational in December 1998.
Net Interest Income
The Company's profitability depends primarily on its net interest income,
which is the difference between the income it receives on its loan and
investment portfolios and its cost of funds, which consists of interest paid
on deposits and borrowed funds. Like most financial institutions, the
Company's interest income and cost of funds are affected significantly by
general economic conditions, particularly changes in market interest rates and
by government policies.
24
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.
The following tables set forth for the periods indicated information for the
Company with respect to average balances of assets and liabilities, as well as
the total dollar amounts of interest income from interest earning assets and
interest expense on interest bearing liabilities, resultant yields or costs,
net interest income, net interest spread, net interest margin and the ratio of
average interest earning assets to average interest bearing liabilities. 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. The December 31, 1997 and 1998 figures are unaudited.
Six Months Ended December 31,
--------------------------------------------------------
1997 1998
--------------------------- ---------------------------
Interest Interest
Average Earned/ Average Average Earned/ Average
Balance(1) Paid Rate(2) Balance(1) Paid Rate(2)
---------- -------- ------- --------- -------- -------
(Dollars in thousands)
Interest Earning Assets:
Loans................... $207,913 $ 9,599 9.23% $281,050 $13,181 9.38%
Mortgage Backed
Securities............. 4,929 208 8.45 3,593 151 8.42
Investment securities
and FHLB stock......... 9,543 296 6.20 37,906 961 5.07
Interest earning
deposits............... 11,578 327 5.64 48,895 1,353 5.53
-------- ------- ------ -------- ------- ------
Total interest earning
assets................. 233,963 $10,430 8.92% 371,444 $15,646 8.42%
Noninterest earning
assets................. 20,793 37,026
-------- --------
Total assets........... $254,756 $408,470
======== ========
Interest Bearing
Liabilities:
Certificates of
deposit................ $126,546 $ 3,528 5.58% $153,566 $ 4,193 5.46%
Savings accounts........ 35,279 656 3.72 57,675 1,024 3.55
Interest bearing demand
and money market
accounts............... 48,449 784 3.24 71,484 971 2.72
-------- ------- ------ -------- ------- ------
Total interest bearing
deposits............... 210,274 4,968 4.73 282,725 6,188 4.38
FHLB advances........... 243 8 6.22 693 22 6.24
Other borrowed funds.... -- -- 0.00 891 24 5.45
-------- ------- ------ -------- ------- ------
Total interest bearing
liabilities........... 210,517 $ 4,976 4.73% 284,309 $ 6,234 4.39%
Demand and other
noninterest bearing
deposits............... 12,667 22,914
Other noninterest
bearing liabilities.... 3,764 6,602
Stockholders' equity.... 27,808 94,644
-------- --------
Total liabilities and
stockholders' equity.. $254,756 $408,469
======== ========
Net interest income
(2).................... $ 5,454 $ 9,412
Net interest spread
(2).................... 4.19% 4.03%
Net interest margin
(2).................... 4.66% 5.07%
Average interest earning
assets to average
interest bearing
liabilities ........... 111.14% 130.65%
- --------
(1) Calculated using average daily balances
(2) Annualized
25
Year Ended June 30,
-------------------------------------------------------------------------------------
1996 1997 1998
--------------------------- --------------------------- ---------------------------
Interest Interest Interest
Average Earned/ Average Average Earned/ Average Average Earned/ Average
Balance(1) Paid Rate Balance(1) Paid Rate Balance(1) Paid Rate
---------- -------- ------- ---------- -------- ------- ---------- -------- -------
(Dollars in thousands)
Interest Earning Assets:
Loans................... $160,823 $14,894 9.26% $182,791 $16,743 9.16% $216,001 $19,888 9.21%
Mortgage Backed
Securities............. 6,715 552 8.22 5,598 464 8.29 4,603 397 8.63
Investment securities
and FHLB stock......... 15,096 854 5.66 12,360 757 6.12 15,540 889 5.72
Interest earning
deposits............... 10,820 575 5.31 10,414 548 5.26 34,863 1,967 5.64
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest earning
assets................. 193,454 $16,875 8.72% 211,163 $18,512 8.77% 271,007 $23,141 8.54%
Noninterest earning
assets................. 18,002 18,974 22,293
-------- -------- --------
Total assets........... $211,456 $230,137 $293,300
======== ======== ========
Interest Bearing
Liabilities:
Certificates of
deposit................ $109,559 $ 6,335 5.78% $119,133 $ 6,599 5.54% $130,591 $ 7,404 5.67%
Savings accounts........ 28,407 1,031 3.63 29,703 1,055 3.55 36,033 1,298 3.60
Interest bearing demand
and money market
accounts............... 36,930 1,162 3.15 42,271 1,345 3.18 50,156 1,413 2.82
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing
deposits............... 174,896 8,528 4.88 191,107 8,999 4.71 216,780 10,115 4.67
FHLB advances........... -- -- 27 1 4.99 156 10 6.69
Other borrowed funds.... 171 15 8.77 -- -- -- 46 3 4.61
-------- ------- ------ -------- ------- ------ -------- ------- ------
Total interest bearing
liabilities............ 175,067 $ 8,543 4.88% 191,134 $ 9,000 4.71% 216,982 $10,128 4.67%
Demand and other
noninterest bearing
deposits............... 6,537 7,955 13,140
Other noninterest
bearing liabilities.... 5,489 4,711 4,168
Stockholders' equity.... 24,363 26,337 59,010
-------- -------- --------
Total liabilities and
stockholders' equity.. $211,456 $230,137 $293,300
======== ======== ========
Net interest income..... $ 8,332 $ 9,512 $13,013
Net interest spread..... 3.84% 4.06% 3.87%
Net interest margin..... 4.31% 4.50% 4.80%
Average interest earning
assets to average
interest bearing
liabilities............ 110.51% 110.48% 124.90%
- --------
(1) Calculated using average daily balances
26
The following table sets forth the amounts of the changes in the Company's
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.
Six Months Ended December 31,
1997 Compared to 1998 Increase
(Decrease) Due to
--------------------------------
Volume Rate Total
---------- -------- ----------
Interest Earning Assets:
Loans....................................... $ 3,371 $ 211 $ 3,582
Mortgage backed securities.................. (56) (1) (57)
Investment securities and FHLB stock........ 879 (214) 665
Interest earning deposits................... 1,052 (26) 1,026
---------- -------- ----------
Total interest income..................... 5,246 (30) 5,216
========== ======== ==========
Interest bearing liabilities:
Certificates of deposit..................... (757) 92 (665)
Savings accounts............................ (417) 49 (368)
Interest bearing demand and money market
accounts................................... (373) 186 (187)
---------- -------- ----------
Total interest bearing deposits........... (1,547) 327 (1,220)
FHLB advances............................... (14) -- (14)
Other borrowed fundings..................... (24) -- (24)
---------- -------- ----------
Total interest bearing liabilities........ (1,585) 327 (1,258)
========== ======== ==========
Year Ended June 30,
-------------------------------------------------------------
1996 Compared to 1997 1997 Compared to 1998
------------------------------ -----------------------------
Increase (Decrease) Due to Increase (Decrease) Due to
------------------------------ -----------------------------
Volume Rate Total Volume Rate Total
--------- -------- --------- --------- ------- ---------
Interest Earning Assets:
Loans................... $ 2,034 $ (185) $ 1,849 $ 3,042 $ 102 $ 3,144
Mortgage backed
securities............. (92) 4 (88) (82) 15 (67)
Investment securities
and FHLB stock......... (155) 58 (97) 195 (63) 132
Interest earning
deposits............... (22) (5) (27) 1,287 133 1,420
--------- -------- --------- --------- ------- ---------
Total interest income.. $ 1,765 $ (128) $ 1,637 $ 4,442 $ 187 $ 4,629
========= ======== ========= ========= ======= =========
Interest bearing
liabilities:
Certificates of
deposit................ $ 554 $ (291) $ 263 $ 635 $ 10 $ 645
Savings accounts........ 47 (22) 25 225 18 243
Interest bearing demand
deposits............... 168 15 183 251 (22) 229
--------- -------- --------- --------- ------- ---------
Total interest on
deposits.............. 769 (298) 471 1,111 6 1,117
FHLB advances........... 1 -- 1 9 -- 9
Other borrowed funds.... (15) -- (15) 2 -- 2
--------- -------- --------- --------- ------- ---------
Total interest
expense............... $ 755 $ (298) $ 457 $ 1,122 $ 6 $ 1,128
========= ======== ========= ========= ======= =========
Financial Condition
The Company's total assets and deposits at December 31, 1998 were $412.0
million and $308.8 million, respectively, which decreased slightly compared to
June 30, 1998 due to the one time withdrawal of approximately $17 million in
temporary funds deposited in June 1998. Excluding the impact of this $17
million
27
withdrawal, total assets and deposits increased 3% and 4%, respectively,
during the six months ended December 31, 1998. Loans increased $13.0 million,
or 5%, to $288.7 million for the six months ended December 31, 1998.
Commercial loans increased to $111.8 million at December 31, 1998 compared
with $100.5 million at June 30, 1998, an increase of 11.2%.
Results of Operations for the Six Month Periods Ended December 31, 1998 and
1997
Net Income. The Company's net income before merger related charges was $2.4
million or $0.24 per diluted share for the six months ended December 31, 1998
as compared to $1.3 million or $0.13 per diluted share for the same period
last year. Including merger related charges of $748,000 on a pre-tax basis,
net income for the six months ended December 31, 1998 was $1.9 million or
$0.19 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 Bancshares, Inc. (WIB). The WIB transaction was
consummated effective March 5, 1999 and will be accounted for as a pooling of
interests.
Net Interest Income. Net interest income increased $4.0 million, or 72.6%,
for the six months ended December 31, 1998 compared with the same period last
year, primarily as a result of a $137.5 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 the Company's January 1998 stock
offering. Average loan balances increased $73.1 million, or 35.2%, which was
concentrated in commercial loans.
Net interest income as a percentage of average interest earning assets (net
interest margin) annualized for the six months ended December 31, 1998
increased to 5.07% from 4.66% for the same period last year. 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
the Company's January 1998 stock offering and the addition of lower cost
deposits acquired with North Pacific Bank. The significant shift in the
Company's funding mix is demonstrated in the Company's ratio of average
interest earning assets to average interest bearing liabilities which
increased to 130.65% for the six months ended December 31, 1998 from 111.14%
for the same period prior year. This ratio indicates that the Company is
funding more of its earning asset growth with noninterest bearing funds
(capital and noninterest bearing deposits). The Company's net interest spread
annualized for the six months ended December 31, 1998 has declined to 4.03%
from 4.19% for the same period last year as a result of the decrease in the
average yield on earning assets to 8.42% for the six months ended December 31,
1998 from 8.92% for the same period last year. Although the average yield on
loans increased to 9.38% for the six months ended December 31, 1998 from 9.23%
for the same period last year due primarily to the growth in commercial loans
with higher yields, the increase in the average balances of investment
securities and interest earning deposits at yields significantly below the
average earning asset yield, 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,
the Company provided $180,000 through operations to maintain its 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, the
Company experienced net charge-offs of $172,000, most of which were related to
loans originated and classified by North Pacific Bank prior to the Company's
acquisition of North Pacific Bank in June 1998. While the Company's loan
portfolio, and in particular commercial loans, have grown substantially over
the past three years, the Company's asset quality has remained very solid as
demonstrated by the nonperforming assets to total assets ratio of 0.10% at
December 31, 1998. Because commercial business lending generally involves
greater risk than those associated with residential and commercial real estate
lending, the Company has increased the portion of its general allowance for
loan losses allocated to its commercial loans over the past three years.
28
Management considers the allowance for loan losses at December 31, 1998 to
be adequate to cover reasonably foreseeable loan losses based on management's
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 $666,000, or 37.6%,
for the six months ended December 31, 1998 compared with the same period last
year. 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 $187,000, or 73.6%, as a
result of growth in business and personal checking accounts. Other income
increased $243,000, or 120.3%, 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 $3.4 million, or
65.3%, for the 1998 period compared to the 1997 period. This $3.4 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 Bancshares, Inc. Excluding merger
related charges, noninterest expense increased $2.7 million, or 51.0%,
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
66.5% of total revenue (the sum of net interest income and noninterest income)
for the six months ended December 31, 1998 as compared to 72.23% for the six
months ended December 31, 1997.
Results of Operations for the Years Ended June 30, 1998 and 1997
Net Income. The Company's earnings increased to $3.6 million, or $0.37 per
diluted share, for the year ended June 30, 1998, compared with $2.3 million,
or $0.24 per diluted share, for the same period in 1997, an increase of 60%.
The increase in net income was primarily attributable to a $59.8 million
increase in the average balance of earning assets and a widening of the net
interest margin. The majority of the increase in earning assets and the
widening of the net interest margin was the result of the large influx of
equity capital ($63 million) from the Company's January 1998 stock offering.
Net Interest Income. Net interest income increased $3.5 million, or 36.8% in
1998 compared to 1997, primarily as a result of a $59.8 million increase in
the average balance of interest earning assets. This growth in interest
earning assets was funded by the $63.0 million in net proceeds raised in the
Company's January 1998 stock offering. Average loan balances increased $33.2
million, or 18.2%, which was concentrated in commercial loans with higher
yields.
Net interest income as a percentage of average interest earning assets (net
interest margin) for 1998 increased to 4.80% from 4.50% in 1997. The increase
was primarily attributable to growth in earning assets combined with a
significant shift in the Company's funding mix due to the funds raised in the
Company's recent stock offering. This is demonstrated by the increase in the
Company's ratio of average interest earning assets to average interest bearing
liabilities to 124.90% for 1998 from 110.51% for 1997 which indicates that the
Company is funding more of its earning asset growth with non-interest bearing
funds (capital and noninterest bearing deposits). The Company's net interest
spread for 1998 has declined to 3.87% from 4.06% for 1997 as a result of the
decrease in the average yield on earning assets to 8.54% for 1998 from 8.77%
for 1997. Although the average yield on loans increased to 9.21% for 1998 from
9.16% for 1997 due primarily to the growth in commercial loans with higher
yields, the increase in the average balances of investment securities and
interest earning deposits at yields significantly below the average earning
asset yield had the effect of decreasing the overall earning asset yield for
1998.
29
Provision for Loan Losses. During 1998, the Company provided $120,000
through operations to maintain its allowance for loan losses at an adequate
level during a time of change in loan portfolio composition and loan growth.
In 1997, the Company recorded a $1.2 million recovery on a multifamily
mortgage loan which had been partially charged off in a prior year. In
reviewing the adequacy of the Company's allowance for loan losses as of June
30, 1997, management determined that the allowance balance was more than
adequate to cover any potential losses in the Company's loan portfolio and
therefore reduced the allowance balance through a $270,000 negative provision
for loan losses.
Management considers the allowance for loan losses at June 30, 1998 to be
adequate to cover reasonably foreseeable loan losses based on management's
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 $444,000, or 13.3%,
for 1998 compared with 1997 primarily due to the $400,000, or 19.9%, increase
in gains on sales of loans for 1998. The increase in gains on sales of loans
was attributable to the 17.1% increase in the volume of mortgages sold ($101.9
million for 1998 compared to $87.0 million for 1997) and the 14.0% increase in
residential mortgage loan originations for 1998 compared to 1997.
Commissions on sales of annuities and securities decreased $69,000, or
31.4%, as a result of lower sales volume due to staff turnover. Service
charges on deposits increased $101,000, or 21.9%, due to growth in personal
and business checking accounts. Other income increased $98,000, or 26.8%, for
1998 due to increases in the volume of fees related to merchant credit card
processing and customer check ordering activity.
Noninterest Expense. Total noninterest expense decreased $12,000, or 0.1%,
in 1998 compared with 1997. Excluding the $1.1 million special SAIF assessment
in 1997, noninterest expense in 1998 increased $1.1 million, or 10.7%,
compared with adjusted 1997 expense levels. The increase in noninterest
expenses during 1998 were concentrated in data processing and marketing
expenses and represent a continuation of the Company's implementation of its
growth strategy, specifically, (1) geographical and product expansion, (2)
development of relationship banking and (3) loan portfolio diversification.
The Company has (i) developed business checking accounts and commercial
lending products and services for businesses and their owners; (ii) introduced
credit and debit cards; (iii) installed an automated response system for
customer account inquiries and (iv) developed products to assist realtors and
potential borrowers to obtain information about loan programs. Total
noninterest expense was 66.01% of total revenue (the sum of net interest
income and noninterest income) for the year ended June 30, 1998 as compared to
77.89% (adjusted for the nonrecurring SAIF assessment) for 1997.
Salaries and employee benefits increased $548,000, or 10.0%, for 1998 as a
result of increases in mortgage commissions, salaries and benefits related to
North Pacific Bank employees for June 1998 and increases in payroll taxes,
health insurance and other employee benefits. Mortgage commissions increased
$146,000, or 21.3%, due to the increased volume of residential mortgage loans
originated and the increased proportion of that volume produced by
commissioned loan officers. The increases in data processing, marketing and
other expenses were due to the Company's implementation of its growth strategy
as described in the paragraph above.
Results of Operations for the Years Ended June 30, 1997 and 1996
Net Income. Net income was $2.3 million, or $0.24 per share, for the year
ended June 30, 1997 compared to $2.8 million, or $0.30 per share, for the year
ended June 30, 1996, an 18.2% decline, primarily as a result of noninterest
expense increasing more rapidly than net interest income, coupled with a
decrease in noninterest income. The increase in noninterest expenses was
attributable to two factors: (1) the expansion in Pierce County of the
Company's branch office network and development of the Company's relationship
banking capacity; and (2) the legislatively-mandated, one-time assessment
levied by the FDIC on all SAIF-insured institutions to recapitalize the SAIF
deposit insurance fund. The decrease in noninterest income was principally the
result of lower gains on sales of loans due to a decline in the volume of
originations of residential mortgage loans.
30
Net Interest Income. Net interest income increased $1.2 million, or 14.2%,
in 1997 compared to 1996 primarily due to a $22.0 million increase in the
average balance of loans. The growth in average loan balances was most
pronounced in commercial loans ($17.7 million of the total $22.0 million
increase). Net interest income increased as a result of an improved net
interest spread coupled with average interest earning assets increasing more
rapidly than average interest bearing liabilities, with the difference funded
by noninterest bearing deposits.
Net interest margin, which is net income divided by average interest earning
assets, for 1997 increased to 4.50% from 4.31% in 1996. The increase was
primarily the result of a growth in earning assets at increased rates coupled
with a decline in the average cost of interest bearing deposits (particularly
for certificates of deposit). Certificates of deposit with scheduled
maturities of one year or less increased to 90% of certificate accounts as of
June 30, 1997 compared to 83% as of June 30, 1996, while average rates on
certificates decreased to 5.54% from 5.78%. The increase in the average yield
on interest earning assets was the result of shifting funds from lower
yielding investments and mortgage backed securities into higher yielding loans
and the overall growth in loans, particularly commercial loans.
Noninterest Income. Total noninterest income decreased $951,000, or 22.1%,
in 1997 compared with 1996. The major component of this category, gains on
sales of loans, decreased $1.0 million, or 34.2% from 1996 to 1997 due to a
lower volume of mortgage loans sold ($87.0 million in 1997 compared to $119.5
million in 1996). The decrease in volume of originations of one- to four-
family residential mortgage loans in 1997 compared with 1996 was due to
weakness in the residential mortgage market and the loss of two key producers
by the end of fiscal 1996. Commissions on sales of annuities and securities
declined $76,000, or 25.7%, as a result of lower sales volume due to staff
turnover. Service charges on deposits increased $109,000, or 30.8%, due to
growth in personal and business checking accounts. In June 1997, the Bank sold
its former branch premises in Shelton, recognizing an $84,000 gain on the
sale.
Noninterest Expense. Total noninterest expense increased $2.7 million, or
31.9%, in 1997 compared with 1996. The increase was attributable to: (i) the
Company's expansion of its branch network in Pierce County and development of
the Company's relationship banking capacity; and (ii) a one-time special
assessment of $1.1 million required by legislation enacted in August 1996, to
recapitalize the SAIF fund of the FDIC. Total noninterest expense (less the
nonrecurring SAIF assessment of $1.1 million) was 77.89% of adjusted revenue
(the sum of net interest income plus noninterest income), for the year ended
June 30, 1997 as compared to 66.68% for the same period in 1996.
Salaries and employee benefits increased $757,000, or 16.1%. The increase
reflects the hiring of a Senior Loan Administrator (in June 1996) and six
commercial lending officers for the Pierce County market (four of which were
hired in June 1996), the staffing additions for the 80th and Pacific branch
(which opened in October 1996) and the full year effect of staffing additions
for the Lakewood branch (which opened in February 1996). Occupancy expense
increased $463,000, or 36.9%, as a result of the operating costs of the new
branch facilities opened during 1996 and 1997 and the full year depreciation
impact of the installation of a bank-wide personal computer network in March
1996. FDIC premiums and special assessment increased $855,000, or 210%, due to
the $1.1 million special assessment mentioned above. The Bank's federal
deposit insurance premiums were reduced by the FDIC from 0.23% (on an
annualized basis) of insured deposits for the quarter ended September 30, 1996
to 0.06% of insured deposits for the semi-annual period ended June 30, 1997.
Income taxes. The Company recorded a Federal income tax benefit of $245,000
for the year ended June 30, 1997 as a result of the reversal of $938,000
deferred tax liability related to the potential recapture of the pre-1988
additions to the tax bad debt reserve which could have been triggered by the
MHC Reorganization in January 1994. Based on subsequent legislation, the
Company reversed the $938,000 deferred tax liability as a reduction of Federal
income tax expense during the year ended June 30, 1997.
31
Liquidity and Capital Resources
The Company's primary sources of funds are customer 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.
The Company 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.
The Company generally maintains sufficient cash and short term investments to
meet short term liquidity needs. At December 31, 1998 cash and cash
equivalents totaled $56.7 million, or 13.8% of total assets, and investment
securities classified as either available for sale or held to maturity with
maturities of one year or less amounted to $6.1 million, or 1.5% of total
assets. At December 31, 1998, the Bank maintained a credit facility with the
FHLB of Seattle for up to 20% of assets or $80.1 million (of which only
$687,000 was outstanding at that date).
To fund the growth of the Company, management's strategy has been to build
core deposits (which the Company defines to include all deposits except public
funds) through the development of its branch office network and commercial
banking relationships. Total deposits decreased $5.3 million, or 1.7%, to
$308.8 million at December 31, 1998 from $314.1 million at June 30, 1998 due
to the one time withdrawal of approximately $17 million in temporary funds
deposited in June, 1998. Excluding the impact of this $17 million withdrawal,
total deposits increased 3.9% during the six months ended December 31, 1998.
This net deposit outflow was concentrated in certificates of deposit which was
somewhat attributable to management lowering offering rates on certificates to
control its overall cost of funds. Historically, the Company has been able to
retain a significant amount of its deposits as they mature. Management
anticipates that the Company 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.
The Company and its subsidiary bank are subject to certain regulatory
capital requirements. As of December 31, 1998, the Company and its subsidiary
bank were classified as a "well capitalized" institution under the criteria
established by the FDIC Act. As of June 30, 1997 and 1998, Heritage Bank was
also classified as a "well capitalized" institution.
Asset/Liability Management
The Company's primary financial objective is to achieve long term
profitability while controlling its exposure to fluctuations in market
interest rates. To accomplish this objective, management has 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 the Company
employs to control its interest rate sensitivity are: (i) sale of most long
term, fixed rate, one- to four-family residential mortgage loan originations
in the secondary mortgage market; (ii) the origination of commercial loans and
residential construction loans at variable interest rates for terms generally
one year or less; and (iii) offers noninterest bearing demand deposit accounts
to businesses and individuals. The longer term objective is to reduce its
dependency on certificates of deposit, which tend to be a higher cost source
of funds and most susceptible to movement from the Company if market interest
rates increase, by increasing its proportion of noninterest bearing demand
deposits, interest bearing demand deposits and money market accounts and
savings deposits.
The Company's asset and liability management strategies have resulted in a
positive "gap" of 15.52% for the 0-3 month period and a relatively neutral one
year "gap" of (0.79)% as of December 31, 1998. These "gaps" measure the
difference between the dollar amount of its 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
32
interest earning amounts, based on certain estimates and assumptions as
discussed below. The acquisition of North Pacific Bank has accelerated the
Company's progress toward its objective by adding more variable rate
commercial loans to the Company's loan portfolio and reducing the percentage
of certificates of deposit to total deposits from 60.4% as of June 30, 1997 to
47.9% as of December 31, 1998. Although management believes that the
implementation of its operating strategies has reduced the potential effects
of changes in market interest rates on the Company's results of operations,
the positive gap for the 0-3 month period indicates that decreases in market
interest rates may adversely affect the Company's results in the near term.
The following table sets forth the estimated maturity or repricing and the
resulting interest rate sensitivity gap of the Company's interest earning
assets and interest bearing liabilities at December 31, 1998 based upon
estimates of expected mortgage prepayment rates and deposit decay rates
consistent with national trends. The Company has 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 the Company's
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................... $ 68,348 $ 67,358 $121,111 $21,061 $10,865 $288,743
Investment securities... 9,249 4,367 23,725 1,600 -- 38,941
FHLB stock.............. 2,062 -- -- -- -- 2,062
Fed funds sold.......... 10,000 -- -- -- -- 10,000
Interest earning
deposits............... 36,355 -- -- -- -- 36,355
-------- -------- -------- ------- ------- --------
Total interest earning
assets............... $126,014 $ 71,725 $144,836 $22,661 $10,865 376,101
Noninterest earning
assets................. 35,882
--------
Total assets.......... $411,983
========
Interest Bearing
Liabilities:
Deposits
Certificates of
deposit.............. $ 46,790 $ 94,671 $ 6,459 $ -- $ -- $147,920
Savings accounts...... 5,118 12,882 31,916 8,390 1,695 60,001
Interest bearing
demand and money
market deposits...... 15,735 25,500 26,024 4,825 972 73,056
-------- -------- -------- ------- ------- --------
Total interest bearing
deposits............... 67,643 133,053 64,399 13,215 2,667 280,977
FHLB advances and other
borrowings............. 3 7 7 328 360 705
-------- -------- -------- ------- ------- --------
Total interest bearing
liabilities............ $ 67,646 $133,060 $ 64,406 $13,543 $ 3,027 281,682
Noninterest bearing
liabilities and
equity................. 130,301
--------
Total liabilities and
equity............... $411,983
========
Rate sensitivity gap.... $ 58,368 $(61,335) $ 80,430 $ 9,118 $ 7,838
Cumulative rate
sensitivity gap:
Amount.................. 58,368 (2,967) 77,463 86,581 94,419
As a percentage of
interest earning
assets................. 15.52% (0.79)% 20.60% 23.02% 25.10%
======== ======== ======== ======= =======
33
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
certain 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, certain assets, such as
adjustable rate mortgages, have features which restrict changes in the
interest rates of such assets both on a short term basis and over the lives of
such assets. Further, in the event of a change in market interest rates,
prepayment and early withdrawal levels could deviate significantly from those
assumed in calculating the tables. Finally, the ability of many borrowers to
service their adjustable rate debt may decrease in the event of a substantial
increase in market interest rates.
Year 2000 Issues
The Company utilizes various computer software programs to provide banking
products and services to its customers. Many existing computer programs use
only two digits to identify a year in the date field and were not designed to
consider the impact of the upcoming change in the century. If not corrected,
many computer applications could fail or create erroneous results by or at the
Year 2000. The Year 2000 issue affects virtually all companies and
organizations.
The Company has completed the identification phase in which management has
determined the extent to which all programs used in its business are Year 2000
compliant. Heritage Bank utilizes a service bureau to perform its most mission
critical data processing services related to its loans, deposits, general
ledger and other financial applications. The service bureau has completed the
software programming for all of its applications used by the Bank. Testing of
these service bureau programs commenced in November 1998 and are expected to
be completed by mid-1999.
The Company has evaluated its major third party business relationships,
including vendors and its borrowers. The significant dependence on the service
bureau creates potential exposure for the Company; however, management fully
expects the service bureau to meet the scheduled timetable for testing which
would ensure that the Company's mission critical applications would be Year
2000 compliant by July 1999. The Company has analyzed the extent that Year
2000 issues could adversely impact their borrowers' business operations,
particularly its commercial borrowers. The Company has performed an initial
assessment of each major borrower and has established an ongoing assessment as
part of the Company's credit granting and loan review process.
Management expects the Company's costs related to Year 2000 issues for 1999
to amount to approximately $20,000 primarily for the testing of service bureau
applications. Of the past expenditures, approximately $43,000 was incurred in
the year ended June 30, 1998 and approximately $120,000 was incurred to
replace the existing North Pacific Bank telephone and voice mail system and
modify the existing Heritage Bank telecommunications systems as part of the
merger of operations which was completed in October 1998.
The Company has prepared a contingency plan with timetables to pursue
various alternatives based on failure of the service bureau to adequately
modify and/or provide sufficient testing and validation resources for the
Company and the service bureau to ensure the mission critical applications are
Year 2000 compliant. The most likely worst case scenario would be that the
testing and validation of the software modifications were not completed by the
scheduled deadline of July 1999. This worst case scenario could increase the
Company's overall expected Year 2000 costs; however, management believes that
this scenario is not probable to occur and if the scenario should occur, that
the impact of these additional costs would not be material to the Company's
financial position and results of operations.
Impact of Inflation and Changing Prices
The primary impact of inflation on the Company's 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
34
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
Effective July 1, 1998, the Company adopted Statement of Accounting
Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130
establishes standards for reporting comprehensive income and its components
(revenues, expenses, gains and losses) in a full set of financial statements.
For the Company, comprehensive income includes net income and changes in
unrealized gains and losses on securities available for sale.
Effective July 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and
Related Information" ("SFAS 131"). SFAS 131 requires public companies to
report financial and descriptive information about its operating segments.
Operating segments are components of a business about which separate financial
information is available that is evaluated regularly by the chief operating
decision-maker in deciding how to allocate resources and in assessing
performance. Based on the requirements of SFAS No. 131, management has
determined that the Company does not have reportable operating segments.
On January 28, 1997, the Securities and Exchange Commission amended their
rules and regulations to require public companies to provide enhanced
descriptions of accounting policies for derivative financial instruments and
derivative commodity instruments in the footnotes to their financial
statements. The accounting policy requirements become effective for all
filings that include financial statements for periods ending after June 15,
1997. The Company had no derivative financial instruments or derivative
commodity instruments at December 31, 1998 or at any time during the three
year and six month period then ended. The Company believes that it is in
compliance with this amended rule.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". This statement establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires that an entity recognize
all derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value.
Under this statement, an entity that elects to apply hedge accounting is
required to establish at the inception of the hedge the method it will use for
assessing the effectiveness of the hedging derivative and the measurement
approach for determining the ineffective aspect of the hedge. Those methods
must be consistent with the entity's approach to managing risk. This statement
is effective for all fiscal quarters of fiscal years beginning after June 15,
1999. The Company had no derivatives as of December 31, 1998 nor does the
Company engage in any hedging activities. The Company does not anticipate that
the adoption of SFAS No. 133 will have a material impact on its financial
position or results of operations.
In October 1998, the FASB issued SFAS No. 134 (which amended Statement No.
65), "Accounting for Certain Mortgage Banking Activities." This statement
establishes accounting and reporting standards for securities retained after
the securitization of mortgage loans. Under this statement, any retained
mortgage-backed securities (after the securitization of a mortgage loan held
for sale) will need to be classified as either "Available for Sale" or
"Trading Securities." However, if the mortgage banking enterprise plans on
selling retained mortgage backed securities before or during the
securitization process, it must be classified as "Trading Securities." This
statement is effective for the first quarter beginning after December 15,
1998. The Company does not expect that the adoption of SFAS No. 134 will have
a material impact on its financial position or results of operations.
35
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to interest rate risk through its lending and deposit
gathering activities. For a discussion of how this exposure is managed and the
nature of changes in the Company's interest rate risk profile during the past
year, see "Asset/Liability Management".
Neither the Company nor the Bank maintain a trading account for any class of
financial instrument, nor do they engage in hedging activities or purchase
high risk derivative instruments. Moreover, neither the Company nor the Bank
are subject to foreign currency exchange rate risk or commodity price risk.
The table below provides information as of December 31, 1998 about the
Company's 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,
------------------------------------------------------------------------
After Fair
1999 2000 2001 2002 2003 2003 Total Value
-------- ------ ------- ------- ------- -------- -------- --------
(Dollars in thousands)
Investment Securities
Amounts maturing:
Fixed rate............. $ 6,120 $3,120 $20,966 $ 200 $ 29 $ 7,472 $ 37,907
Weighted average
interest rate......... 5.59% 5.91% 5.60% 4.68% 6.75% 7.51%
Adjustable Rate........ 1,034 -- -- -- -- -- 1,034
Weighted average
interest rate......... 6.65% -- -- -- -- --
-------- ------ ------- ------- ------- -------- -------- --------
Totals............... 7,154 3,120 20,966 200 29 7,472 $ 38,941 $ 39,110
Loans
Amounts maturing:
Fixed rate............. $ 14,802 $2,919 $ 3,977 $ 8,236 $ 8,308 $112,807 $151,049
Weighted average
interest rate......... 9.16% 10.22% 10.02% 9.44% 9.41% 8.48%
Adjustable rate........ 44,604 3,571 8,930 3,431 4,815 68,793 134,144
Weighted average
interest rate......... 9.63% 9.59% 9.21% 9.64% 9.35% 8.45%
-------- ------ ------- ------- ------- -------- -------- --------
Totals............... $ 59,406 $6,490 $12,907 $11,667 $13,123 $181,600 $285,193 $289,944
Certificates of Deposit
Amounts maturing:
Fixed rate............. $141,461 $4,313 $ 540 $ 272 $ 1,334 $ -- $147,920 $148,179
Weighted average
interest rate......... 5.24% 4.94% 4.38% 4.96% 5.04% --
FHLB Advances
Amounts maturing:
Fixed rate............. $ 54 $ 30 $ 32 $ 34 $ 34 $ 503 $ 687 $ 719
Weighted average
interest rate......... 5.95% 5.95% 5.95% 5.95% 5.95% 6.30%
Other Borrowings
Amounts maturing:
Fixed rate............. $ 10 $ 7 $ -- -- -- -- $ 17 $ 16
Weighted average
interest rate......... 5.25% 5.25% -- -- -- --
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.
36
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 31, 1999 (the "Proxy Statement") for
the annual meeting of shareholders to he held April 27, 1999.
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.
37
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 as of October 1, 1997.(1)
Severance Agreement between the Company and Brian L. Vance, effective
10.3 October 1, 1997.(1)
Severance Agreement between the Company and John D. Parry, effective
10.4 October 1, 1997.(1)
10.5 Form of Severance Agreement entered into between the Company and seven
additional executives, effective as of October 1, 1997.(1)
10.6 1997 Stock Option and Restricted Stock Award Plan(3)
21.0 Subsidiaries of the Company
23.0 Consent of KPMG LLP
24.0 Power of Attorney dated February 25, 1999
27.0 1998 Financial Data Schedule
- --------
(1) Incorporated by reference to the Registration Statement on Form S-1 (Reg.
No. 333-35573) declared effective on November 12, 1997.
(2) Incorporated by reference to the definitive Proxy Statement dated
September 14, 1998 for the Annual Meeting of Shareholders held on October
15, 1998.
(3) Incorporated by reference to the Registration Statement on Form S-8 (Reg.
No. 333-57513).
(b) Reports on Form 8-K. The Company filed three reports on Form 8-K between
October 1, 1998 and December 31, 1998 as follows:
(1) October 8, 1998 Form 8-K announcing that an agreement had been
reached for the Company to acquire Washington Independent Bankshares, Inc.
(2) October 29, 1998 Form 8-K announcing that the Board of the Company
voted to change the Company's fiscal year from June 30 to December 31.
(3) December 30, 1998 Form 8-K announcing that the Company and Harbor
Bancorp, Inc. had mutually agreed to terminate the agreement calling for
the Company to acquire Harbor.
38
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/ James Hastings
-------------------------------------
James Hastings
Vice President and Treasurer
Dated: March 29, 1999
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 29, 1999, as
attorney-in-fact for the following directors who constitute a majority of the
board of directors.
Lynn M. Brunton John A. Clees
Daryl D. Jensen H. Edward Odegard
James P. Senna Peter K. Wallerich
Philip S. Weigand
/s/ Donald V. Rhodes
-------------------------------------
Donald V. Rhodes
Attorney-in-fact
March 29, 1999
39
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
June 30, 1996, 1997, 1998 and December 31, 1998
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Independent Auditors' Report.............................................. F-2
Consolidated Statements of Financial Condition--June 30, 1998 and December
31, 1998................................................................. F-3
Consolidated Statements of Income--for the years ended June 30, 1996, 1997
and 1998 and for the six month periods ended December 31, 1997 and 1998.. F-4
Consolidated Statements of Stockholders' Equity and Comprehensive Income--
Years ended June 30, 1996, 1997 and 1998 and for the six months ended
December 31, 1998........................................................ F-5
Consolidated Statements of Cash Flows--Years ended June 30, 1996, 1997 and
1998 and for the six month periods ended December 31, 1997 and 1998...... 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 June 30, 1998 and December 31, 1998, and the related consolidated
statements of income, stockholders' equity and comprehensive income, and cash
flows for each of the years in the three-year period ended June 30, 1998 and
for the six month period ended December 31, 1998. These consolidated financial
statements are the responsibility of the Corporation's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Heritage Financial Corporation and subsidiaries as of June 30 and December
31, 1998, and the results of their operations and their cash flows for each of
the years in the three-year period ended June 30, 1998 and for the six month
period ended December 31, 1998 in conformity with generally accepted
accounting principles.
/s/ KPMG LLP
Seattle, Washington
January 29, 1999
F-2
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Dollars in thousands)
June 30, December 31,
1998 1998
-------- ------------
ASSETS
------
Cash on hand and in banks............................... $ 12,065 $ 10,369
Interest earning deposits............................... 50,542 36,355
Federal funds sold...................................... 12,000 10,000
Investment securities available for sale................ 9,041 25,792
Investment securities held to maturity.................. 29,731 13,149
Loans held for sale..................................... 6,411 7,618
Loans receivable........................................ 269,355 281,125
Less: Allowance for loan losses......................... (3,542) (3,550)
-------- --------
Loans, net............................................ 265,813 277,575
Real estate owned....................................... 82 --
Premises and equipment, at cost, net.................... 15,923 15,878
Federal Home Loan Bank stock, at cost................... 1,985 2,062
Accrued interest receivable............................. 2,275 2,106
Prepaid expenses and other assets....................... 1,352 2,707
Goodwill................................................ 8,631 8,372
-------- --------
$415,851 $411,983
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Deposits................................................ $314,120 $308,811
Advances from Federal Home Loan Bank.................... 698 687
Other borrowings........................................ 1,132 17
Advance payments by borrowers for taxes and insurance... 419 476
Accrued expenses and other liabilities.................. 4,412 5,524
Deferred Federal income taxes........................... 1,183 1,035
-------- --------
321,965 316,550
-------- --------
Stockholders' equity:
Common stock, no par, 15,000,000 shares authorized;
9,656,176 and 9,793,145 shares outstanding at June
30, 1998 and December 31, 1998, respectively......... 70,515 70,969
Unearned compensation--ESOP and Other................. (1,328) (1,241)
Retained earnings, substantially restricted........... 24,696 25,699
Unrealized gain on securities available for sale, net
of deferred taxes.................................... 4 6
-------- --------
Total stockholders' equity.......................... 93,887 95,433
Commitments and contingencies...........................
-------- --------
$415,851 $411,983
======== ========
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 June 30 December 31
------------------------ -------------------
1996 1997 1998 1997 1998
------- ------- ------- ----------- -------
(unaudited)
Interest income:
Loans........................... $14,894 $16,743 $19,888 $9,599 $13,181
Mortgage backed securities...... 552 464 397 208 151
Investment securities and
Federal Home Loan Bank
dividends...................... 854 757 889 296 961
Interest bearing deposits....... 575 548 1,967 327 1,174
Interest on fed funds sold...... -- -- -- -- 179
------- ------- ------- ------ -------
Total interest income......... 16,875 18,512 23,141 10,430 15,646
------- ------- ------- ------ -------
Interest expense:
Deposits........................ 8,528 8,999 10,115 4,968 6,188
Other borrowings................ 15 1 13 8 46
------- ------- ------- ------ -------
Total interest expense........ 8,543 9,000 10,128 4,976 6,234
------- ------- ------- ------ -------
Net interest income......... 8,332 9,512 13,013 5,454 9,412
Provision for loan losses....... -- (270) 120 60 180
------- ------- ------- ------ -------
Net interest income after
provision for loan losses.. 8,332 9,782 12,893 5,394 9,232
------- ------- ------- ------ -------
Noninterest income:
Gains on sales of loans, net.... 3,049 2,006 2,406 1,102 1,297
Commissions on sales of
annuities and securities....... 296 220 151 75 101
Services charges on deposits.... 353 462 563 254 441
Rental income................... 221 210 208 104 112
Gain on sale of premises........ -- 84 -- 36 43
Other income.................... 379 365 463 202 445
------- ------- ------- ------ -------
Total noninterest income...... 4,298 3,347 3,791 1,773 2,439
------- ------- ------- ------ -------
Noninterest expense:
Salaries and employee benefits.. 4,711 5,468 6,016 2,963 4,381
Building occupancy.............. 1,254 1,717 1,768 857 1,239
FDIC premiums and special
assessment..................... 407 1,262 135 65 72
Data processing................. 493 534 700 324 568
Marketing....................... 162 257 380 181 263
Office supplies and printing.... 229 243 268 128 187
Goodwill amortization........... -- -- -- -- 288
Other........................... 1,166 1,624 1,826 702 1,631
------- ------- ------- ------ -------
Total noninterest expense..... 8,422 11,105 11,093 5,220 8,629
------- ------- ------- ------ -------
Income before Federal income
tax expense (benefit)...... 4,208 2,024 5,591 1,947 3,042
Federal income tax expense
(benefit)........................ 1,435 (245) 1,963 691 1,118
------- ------- ------- ------ -------
Net income.................. $ 2,773 $ 2,269 $ 3,628 $1,256 $ 1,924
======= ======= ======= ====== =======
Basic earnings per common share... $0.30 $0.24 $0.38 $0.14 $0.20
Diluted earnings per common
share............................ $0.30 $0.24 $0.37 $0.13 $0.19
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,
1995................... 1,805 $ 1,805 $ 4,062 $ -- $17,198 $-- $23,065
Restricted stock award.. 1 1 5 -- -- -- 6
Net income.............. -- -- -- 2,773 -- 2,773
Cash dividend declared.. -- -- -- (211) -- (211)
----- ------- ------- ------- ------- ---- -------
Balance at June 30,
1996................... 1,806 $ 1,806 4,067 -- 19,760 -- 25,633
Exercise of stock
options................ 4 4 36 -- -- -- 40
Net income.............. -- -- -- 2,269 -- 2,269
Cash dividend declared.. -- (228) -- (228)
----- ------- ------- ------- ------- ---- -------
Balance at June 30,
1997................... 1,810 1,810 4,103 -- 21,801 -- 27,714
Offering proceeds....... 6,481 64,352 -- (1,322) -- -- 63,030
Earned ESOP shares...... 3 17 -- 37 -- -- 54
Conversion transaction.. 1,329 4,223 (4,103) -- -- -- 120
Exercise of stock
options................ 30 70 -- -- -- -- 70
Restricted stock award.. 3 43 -- (43) -- -- --
Net income.............. -- -- -- 3,628 -- 3,628
Net increase in
unrealized gain on
securities available
for sale, net of
taxes.................. -- -- -- -- 4 4
Cash dividend declared.. -- -- -- (733) -- (733)
----- ------- ------- ------- ------- ---- -------
Balance at June 30,
1998................... 9,656 70,515 -- (1,328) 24,696 4 93,887
Earned ESOP shares...... 4 11 -- 44 -- -- 55
Exercise of stock
options................ 136 486 -- -- -- -- 486
Restricted stock award
terminated............. (3) (43) -- 43 -- -- --
Net income.............. -- -- 1,924 1,924
Net increase in
unrealized gain on
securities available
for sale, net of
taxes.................. -- -- -- -- 2 2
Cash dividend declared.. -- -- -- -- (921) -- (921)
----- ------- ------- ------- ------- ---- -------
Balance at December 31,
1998................... 9,793 $70,969 $ -- $(1,241) $25,699 $ 6 $95,433
===== ======= ======= ======= ======= ==== =======
Six months
ended
Year ended June 30 December 31
-------------------- -------------
Comprehensive Income 1996 1997 1998 1997 1998
-------------------- ------ ------ ------ ------ ------
(unaudited)
Net income.......................... $2,773 $2,269 $3,628 $1,256 $1,923
Increase in unrealized gain on
securities available for sale,
net of tax......................... -- -- -- -- 2
------ ------ ------ ------ ------
Comprehensive income................ $2,773 $2,269 $3,628 $1,256 $1,925
====== ====== ====== ====== ======
See accompanying notes to consolidated financial statements.
F-5
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Year Ended Six Months Ended
June 30 December 31
--------------------------- --------------------
1996 1997 1998 1997 1998
------- -------- -------- ----------- --------
(Unaudited)
Cash flows from operating
activities:
Net income............... $ 2,773 $ 2,269 $ 3,628 $ 1,256 $ 1,924
Adjustments to reconcile
net income to net cash
provided by operating
activities, net of
effect of acquisition:
Depreciation and
amortization.......... 349 996 1,000 501 543
Deferred loan fees, net
of amortization....... 35 11 (149) (38) (172)
Provision for loan
losses................ -- (270) 120 60 180
Net increase in loans
held for sale......... 615 (1,037) (88) 1,281 (1,206)
Deferred Federal income
tax expense
(benefit)............. 262 (549) (17) -- (148)
Federal Home Loan Bank
stock dividends....... (99) (111) (129) (61) (77)
Recognition of
compensation related
to ESOP............... -- -- 54 -- 57
Net change in accrued
interest receivable,
prepaid expenses and
other assets, and
accrued expenses and
other liabilities..... 411 392 (397) (1,111) (3)
------- -------- -------- ------- --------
Net cash provided by
operating
activities.......... 4,346 1,701 4,022 1,888 1,098
------- -------- -------- ------- --------
Cash flows from investing
activities, net of effect
of acquisition:
Loans originated, net of
principal payments and
loan sales.............. (11,211) (37,115) (18,128) (8,541) (11,599)
Principal payments of
mortgage backed
securities.............. 1,493 825 1,335 457 588
Maturities of investment
securities held to
maturity................ 13,300 9,160 6,271 2,770 17,110
Purchase of investment
securities held to
maturity................ (10,445) (2,345) (20,748) (1,950) (1,099)
Purchase of investment
securities available for
sale.................... -- -- -- -- (16,683)
Purchase of premises and
equipment............... (2,204) (2,023) (353) (182) (579)
Cash acquired, net of
cash paid for
acquisition............. -- -- 10,573 -- --
------- -------- -------- ------- --------
Net cash used in
investing
activities.......... (9,067) (31,498) (21,050) (7,446) (12,262)
------- -------- -------- ------- --------
Cash flows from financing
activities, net of effect
of acquisition:
Net increase (decrease)
in deposits............. 16,322 18,662 22,049 14,106 (5,309)
Net increase (decrease)
in FHLB advances........ -- 890 (890) (890) (11)
Net increase (decrease)
in other borrowed
funds................... (3,252) -- 185 -- (1,114)
Net increase (decrease)
in advance payments by
borrowers for taxes and
insurance............... (100) (62) (54) 2 57
Cash dividends paid...... (211) (228) (342) -- (826)
Issuance of restricted
stock award and exercise
of stock options........ 6 40 70 -- 484
Proceeds received and
held for stock
conversion.............. -- -- -- 72,506 --
Net proceeds from stock
offering................ -- 63,030 -- --
------- -------- -------- ------- --------
Net cash provided by
(used in) financing
activities.......... 12,765 19,302 84,048 85,724 (6,719)
------- -------- -------- ------- --------
Net increase
(decrease) in cash
and cash
equivalents......... 8,044 (10,495) 67,020 80,166 (17,883)
Cash and cash equivalents
at beginning of year...... 10,038 18,082 7,587 7,587 74,607
------- -------- -------- ------- --------
Cash and cash equivalents
at end of year............ $18,082 $ 7,587 $ 74,607 $87,753 $ 56,724
======= ======== ======== ======= ========
Supplemental disclosures of
cash flow information:
Cash payments for:
Interest expense......... $ 8,527 $ 8,945 $ 10,420 $ 5,010 $ 6,145
Federal income taxes..... 1,395 620 1,578 540 1,360
Supplemental disclosure of
noncash investing
activities:
Mortgage loans
transferred to real
estate owned............ -- -- 82 -- (82)
See accompanying notes to consolidated financial statements.
F-6
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands)
(1) Summary of Significant Accounting Policies
(a) Description of Business
Heritage Financial Corporation (the Company) is a bank holding company
incorporated in the State of Washington in August 1997. The Company was
organized for the purpose of acquiring all of the capital stock of Heritage
Bank upon its reorganization from a mutual holding company form of
organization to the stock holding company form of organization.
The Company is primarily engaged in the business of planning, directing and
coordinating the business activities of its wholly owned subsidiary: Heritage
Bank (the 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). The Bank conducts business from
its main office in Olympia, Washington and its eleven branch offices located
in Thurston, Pierce and Mason Counties. Effective June 12, 1998, the Company
acquired North Pacific Bank, a Washington-chartered commercial bank which was
merged into the Bank effective November 20, 1998.
The business of Heritage Bank consists primarily of focusing on lending and
deposit relationships with small businesses 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 Washington. The Bank also makes residential construction loans, income
property loans and consumer loans. Although the Bank has a diversified loan
portfolio and its market area enjoys a stable economic climate, a substantial
portion of its borrowers' ability to repay these loans is dependent upon the
economic stability of the major employers, Federal, State and local
governments.
(b) Basis of Presentation
The accounting and reporting policies of the Company and its subsidiaries
conform to generally accepted accounting principles and to general practices
within the financial institutions industry, where applicable. In preparing the
consolidated financial statements, management makes estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of financial statements and the
reported amounts of income and expense during the reported periods. Actual
results could differ from these estimates.
The accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries. The financial statements shown
herein prior to the January 8, 1998 stock conversion are for Heritage Bank
only as the Company did not engage in any material transactions until after
January 8, 1998. The par value of common stock and additional paid-in capital
of the Company have been restated to reflect the new par value of the holding
company which became effective January 8, 1998. The formation of the holding
company was treated in a manner similar to a pooling-of-interests. 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.
(c) Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents includes
cash on hand and in banks and interest bearing deposits and fed funds sold.
F-7
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(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 interest method.
Securities available for sale are carried at fair value. Unrealized gains and
losses on securities available for sale are excluded from earnings and are
reported net of tax as a separate component (Accumulated other comprehensive
income) of stockholders' equity until realized. Realized gains and losses on
sale are computed on the specific identification method.
(e) Loans Receivable and Loans Held for Sale
Loans are generally recorded at cost, net of discounts, unearned fees and
deferred fees. Discounts and premiums on purchased loans are amortized using
the interest method over the remaining contractual life, adjusted for actual
prepayments. Mortgage loans held for sale are carried at the lower of
amortized cost or market value determined on an aggregate basis. Any loan that
management determines will not be held to maturity is classified as held for
sale at the time of origination, purchase or securitization. Unrealized losses
on such loans are included in income.
(f) Loan Fees
Loan origination fees and certain direct origination costs are deferred and
amortized as an adjustment of the yields of the loans over their contractual
lives, adjusted for prepayment of the loans, using the interest method. In the
event loans are sold, the deferred net loan origination fees or costs are
recognized as a component of the gains or losses on the sales of loans.
(g) Allowance for Loan Losses
A valuation allowance for loans is based on management's estimate of the
amount necessary to recognize possible losses inherent in the loan portfolio.
In determining the level to be maintained, management evaluates many factors
including the borrowers' ability to repay, economic and market trends and
conditions, holding costs and absorption periods. In the opinion of
management, the present allowance is adequate to absorb reasonably foreseeable
loan losses.
While management uses available information to recognize losses on these
loans, future additions to the allowances may be necessary based on changes in
economic conditions, particularly in the western Washington region. In
addition, various regulatory agencies, as an integral part of their
examination process, periodically review the Bank's allowance for losses on
loans. Such agencies may require the Bank to make additions to the allowance
based on their judgments about information available to them at the time of
their examinations.
(h) Impaired Loans
The accrual of interest on loans is discontinued and the loan is considered
impaired when, in the opinion of management, the collectibility of principal
or interest is in doubt or generally when the loans are contractually past due
90 days or more with respect to principal or interest. When accrual of
interest is discontinued on a loan, the interest accrued but not collected is
charged against operations. Thereafter, payments received are generally
applied to principal. However, based on management's assessment of the
ultimate collectibility of an impaired
F-8
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
or nonaccrual loan, interest income may be recognized on a cash basis.
Impaired loans and other nonaccrual loans (smaller balance, homogeneous 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
The Bank sells mortgage loans primarily on a servicing released basis and
recognizes a cash or a present value gain or loss. A cash gain or loss is
recognized to the extent that the sales proceeds of the mortgage loans sold
exceed or are less than the net book value at the time of sale.
Loan servicing income is recorded when earned. Loan servicing costs are
charged to expense as incurred.
(j) Real Estate Owned
Real estate acquired by the Bank in satisfaction of debt is recorded at fair
value at time of foreclosure and is carried at the lower of the new cost basis
or fair value. Subsequently, foreclosed assets are carried at the lower of
cost or fair value less estimated costs to sell.
(k) Premises and Equipment
Premises and equipment are stated at cost less accumulated depreciation and
amortization. Depreciation and amortization are computed using the straight-
line method over the estimated useful lives of the assets. The estimated
useful lives used to compute depreciation and amortization include buildings
and building improvements, 30 to 40 years; and furniture, fixtures and
equipment, 3 to 10 years.
(l) Goodwill
Goodwill represents the costs in excess of net assets acquired arising from
the purchase of North Pacific Bank and is being amortized on a straight line
basis over 15 years. The Company will periodically evaluate goodwill for
impairment.
(m) Federal Income Taxes
Deferred 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 years 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.
(n) Employee Stock Ownership Plan
Heritage Bank sponsors an Employee Stock Ownership Plan (ESOP). The ESOP
purchased 2% of the common stock issued in the January 1998 stock offering and
borrowed from the Company in order to fund the purchase of the Company's
common stock. The loan to the ESOP will be repaid principally from the Bank's
contributions to the ESOP. The Bank's contributions will be sufficient to
service the debt over the 15 year loan term at the interest rate of 8.5%,
after the effect of cash dividends on unallocated shares. As the debt is
repaid,
F-9
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
shares are released and allocated to plan participants based on the proportion
of debt service paid during the year. As shares are released, compensation
expense is recorded equal to the then current market price of the shares and
the shares become outstanding for earnings per share calculations. Cash
dividends on allocated shares are recorded as a reduction of retained earnings
and paid or distributed directly to participants' accounts. Cash dividends on
unallocated shares are recorded as a reduction of debt and accrued interest.
(o) Recent Financial Accounting Pronouncements
Effective July 1, 1998, the Company adopted Statement of Accounting
Standards No. 130, "Reporting Comprehensive Income" ("SFAS 130"). SFAS 130
establishes standards for reporting comprehensive income and its components
(revenues, expenses, gains and losses) in a full set of financial statements.
For the Company, comprehensive income includes net income and the change in
unrealized gains and losses on securities available for sale.
Effective July 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and
Related Information" ("SFAS 131"). SFAS 131 requires public companies to
report financial and descriptive information about its operating segments.
Operating segments are components of a business about which separate financial
information is available that is evaluated regularly by the chief operating
decision-maker in deciding how to allocate resources and in assessing
performance. Based on the requirements of SFAS No. 131, management has
determined that the Company does not have reportable operating segments.
On January 28, 1997, the Securities and Exchange Commission amended their
rules and regulations to require public companies to provide enhanced
descriptions of accounting policies for derivative financial instruments and
derivative commodity instruments in the footnotes to their financial
statements. The accounting policy requirements become effective for all
filings that include financial statements for periods ending after June 15,
1997. The Company had no derivative financial instruments or derivative
commodity instruments at December 31, 1998 or at any time during the three
years ended June 30, 1998 and the six month period ended December 31, 1998.
The Company believes that it is in compliance with this amended rule.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities". This statement establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires that an entity recognize
all derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value.
Under this statement, an entity that elects to apply hedge accounting is
required to establish at the inception of the hedge the method it will use for
assessing the effectiveness of the hedging derivative and the measurement
approach for determining the ineffective aspect of the hedge. Those methods
must be consistent with the entity's approach to managing risk. This statement
is effective for all fiscal quarters of fiscal years beginning after June 15,
1999. The Company had no derivatives as of December 31, 1998 nor does the
Company engage in any hedging activities. The Company does not anticipate that
the adoption of SFAS No. 133 will have a material impact on its financial
position or results of operations.
In October 1998, the FASB issued SFAS No. 134 (which amended SFAS No. 65),
"Accounting for Certain Mortgage Banking Activities." This statement
establishes accounting and reporting standards for securities retained after
the securitization of mortgage loans. Under this statement, any retained
mortgage-backed securities (after the securitization of a mortgage loan held
for sale) will need to be classified as either "Available for Sale"
F-10
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
or "Trading Securities." However, if the mortgage banking enterprise plans on
selling retained mortgage backed securities before or during the
securitization process, it must be classified as "Trading Securities." This
statement is effective for the first quarter beginning after December 15,
1998. The Company does not expect that the adoption of SFAS No. 134 will have
a material impact on its financial position or results of operations.
(2) Business Combinations
(a) North Pacific Bank
The Company completed the acquisition of North Pacific Bank effective June
12, 1998. The Company paid the former stockholder of North Pacific
Bancorporation $17.5 million in cash for the common stock of North Pacific
Bancorporation. This acquisition was treated as a purchase for accounting
purposes. Accordingly, under generally accepted accounting principles, the
assets and liabilities of North Pacific Bank have been recorded on the books
of the Company at their respective fair values at the date the acquisition was
consummated. Goodwill, the excess of the purchase price (cost) over the net
fair value of the assets and liabilities acquired, was recorded at $8.6
million. Accumulated amortization of goodwill amounted to $288 as of December
31, 1998. The following are the fair values of assets acquired and liabilities
assumed as of the June 12, 1998 acquisition date:
Cash acquired, net of cash paid for acquisition..................... $10,573
Securities.......................................................... 12,277
Loans, net.......................................................... 48,620
Premises and equipment.............................................. 4,397
Goodwill............................................................ 8,631
Other assets........................................................ 499
-------
Total assets...................................................... $84,997
=======
Deposits............................................................ $82,410
FHLB advances....................................................... 698
Other borrowed funds................................................ 947
Deferred federal income taxes....................................... 499
Other liabilities................................................... 443
-------
Total liabilities................................................. $84,997
=======
The financial statements for the year ended June 30, 1998 include the
operations of North Pacific Bank from June 12, 1998 to June 30, 1998.
Effective November 20, 1998, the operations of North Pacific Bank were merged
with Heritage Bank. The following information presents the actual results of
operations for the year ended June 30, 1998 and the proforma results of
operations for the years ended June 30, 1998, 1997 and 1996, as though the
acquisition had occurred on July 1, 1995. The proforma results do not
necessarily indicate the actual result that would have been obtained nor are
they necessarily indicative of the future operations of the combined
companies.
Years Ended June 30,
Unaudited proforma
Actual -----------------------
1998 1996 1997 1998
------- ------- ------- -------
(in thousands, except per share
amounts)
Net interest income before provision for
loan loss................................ $13,013 $11,125 $12,665 $16,068
Net income................................ 3,628 2,480 2,002 3,090
Earnings per common share:
Basic................................... $0.38 $0.27 $0.21 $0.33
Diluted................................. $0.37 $0.27 $0.21 $0.31
F-11
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(b) Washington Independent Bancshares, Inc
On September 28, 1998, the Company entered into a definitive merger
agreement with Washington Independent Bancshares, Inc. (Washington
Independent) whereby the Company would acquire all of the outstanding common
stock of Washington Independent (whose wholly owned subsidiary is Central
Valley Bank). The transaction closed on March 5, 1999, and the Company
exchanged 1,058,200 shares of its common stock for all of the outstanding
Washington Independent common stock. This transaction is expected to be
accounted for as a pooling of interests and accordingly, the Company's
historical consolidated financial statements presented in future reports will
be restated to include the accounts and results of operations of Washington
Independent.
(3) Loans Receivable and Loans Held for Sale
Loans receivable and loans held for sale consist of the following:
June 30, December 31,
1998 1998
-------- ------------
Commercial loans.................................... $100,489 $111,817
Real Estate Mortgages:
One to four family residential.................... 97,598 93,442
Five or more family residential and commercial
real estate...................................... 57,158 55,121
-------- --------
Total Real Estate Mortgage........................ 154,756 148,563
Real Estate Construction:
One to four family residential.................... 18,192 24,922
Five or more family residential and commercial
real estate...................................... 527 2,124
-------- --------
Total Real Estate Construction...................... 18,719 27,046
Consumer............................................ 3,030 2,717
-------- --------
Subtotal.......................................... 276,994 290,143
Unamortized yield adjustments....................... (1,228) (1,400)
-------- --------
Total Loans Receivable and Loans Held for Sale.... $275,766 $288,743
======== ========
Accrued interest on loans receivable amounted to $1,553 and $1,561 as of
June 30, 1998 and December 31, 1998, respectively. The Company had $369 and
$392 of impaired loans which are nonaccruing as of June 30, 1998 and December
31, 1998, respectively. The weighted average interest rate on loans was 8.8%
and 8.5% as of June 30, 1998 and December 31, 1998, respectively.
Details of certain mortgage banking activities are as follows:
June 30, December 31,
1998 1998
-------- ------------
Loans held for sale at lower of cost or market....... $6,411 $7,618
Loans serviced for others............................ 25,648 18,832
Commitments to sell mortgage loans................... 12,418 11,533
Commitments to fund mortgage loans (at interest rates
approximating
market rates)
Fixed rate......................................... 6,266 4,704
Variable or adjustable rate........................ 249 --
F-12
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Servicing fee income from loans serviced for others amounted to $90, $75,
$60 and $79 for the years ended June 30, 1996, 1997 and 1998 and the six
months ended December 31, 1998, respectively.
Commitments to sell mortgage loans are made primarily during the period
between the taking of the loan application and the closing of the mortgage
loan. The timing of making these sale commitments is dependent upon the timing
of the borrower's election to lock-in the mortgage interest rate and fees
prior to loan closing. Most of these sale commitments are made on a best-
efforts basis whereby the Bank is only obligated to sell the mortgage if the
mortgage loan is approved and closed by the Bank.
As of December 31, 1998, the Company had $28.5 million in other loan
commitments (which includes business and consumer credit lines ), $10.7
million in real estate loan commitments outstanding, and $0.8 million in
commitments under letters of credit.
(4) Allowance for Loan Losses
Activity in the allowance for loan losses is summarized as follows:
Six Months
Year Ended June 30, Ended
--------------------- December 31,
1996 1997 1998 1998
------ ------ ------ ------------
Balance at beginning of period........... $1,720 $1,873 $2,752 $3,542
Provision.............................. -- (270) 120 180
Recoveries............................. 153 1,152 -- 9
Charge offs............................ -- (3) -- (181)
Acquired with North Pacific Bank....... -- -- 670 --
------ ------ ------ ------
Balance at end of period................. $1,873 $2,752 $3,542 $3,550
====== ====== ====== ======
In May 1996, the Bank sold its interest in two loans which were partially
charged off. This sale resulted in an excess of net proceeds over the book
basis of these loans of $1.3 million. The Bank recorded a recovery of $148 in
1996 which was the pro rata portion of the sale proceeds received in cash
versus the amount the Bank financed for the purchaser. The additional $1,152
was recognized as a recovery in 1997 when the Bank received additional
collateral on this financing.
(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
--------- ---------- ---------- -------
June 30, 1998
U.S. Government and its agencies... $ 8,022 $ 6 $-- $ 8,028
Corporate notes.................... 1,013 -- -- 1,013
------- ---- ---- -------
$9,035 $ 6 $-- $ 9,041
======= ==== ==== =======
December 31, 1998
U.S. Government and its agencies... $21,093 $ 56 $(47) $21,102
Mortgage backed and related
securities:
Collateralized mortgage
obligations..................... 2,690 -- (10) 2,680
Other............................ 1,000 -- -- 1,000
Corporate notes.................... 1,001 9 -- 1,010
------- ---- ---- -------
Totals......................... $25,784 $ 65 $(57) $25,792
======= ==== ==== =======
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, 1998 are shown below:
Amortized Fair
cost value
--------- -------
Due in one year or less............................... $ 3,993 $ 4,028
Due after one year through three years................ 17,601 17,584
Due after five years through ten years................ 500 500
Due after ten years................................... 3,690 3,680
------- -------
Totals................................................ $25,784 $25,792
======= =======
There were no sales of investment securities available for sale during the
periods ended June 30, 1996, 1997, 1998, and December 31, 1998.
Accrued interest on investment securities available for sale amounted to
$131 and $201 as of June 30, 1998 and December 31, 1998, respectively.
At June 30, 1998 and December 31, 1998, investment securities available for
sale with amortized cost values of $2,415 and $1,997 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
--------- ---------- ---------- -------
June 30, 1998
U.S. Government and its agencies.... $22,996 $ 5 $(22) $22,979
Mortgage backed securities:
FNMA certificates................. 944 48 (8) 984
FHLMC certificates................ 970 61 -- 1,031
GNMA certificates................. 1,930 138 -- 2,068
Municipal bonds..................... 2,891 25 ( 3) 2,913
------- ---- ---- -------
$29,731 $277 $(33) $29,975
======= ==== ==== =======
December 31, 1998
U.S. Government and its agencies.... $ 7,348 $ 10 $ (3) $ 7,355
Mortgage backed securities:
FNMA certificates................. 734 10 -- 743
FHLMC certificates................ 851 22 -- 873
GNMA certificates................. 1,677 54 -- 1,732
Municipal bonds..................... 2,539 76 -- 2,615
------- ---- ---- -------
$13,149 $172 $ (3) $13,318
======= ==== ==== =======
The amortized cost and fair value of investment securities held to maturity,
by contractual maturity, at December 31, 1998 are shown below:
F-14
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Amortized Fair
cost value
--------- -------
Due in one year or less............................... $ 2,092 $ 2,096
Due after one year through three years................ 6,502 6,530
Due after three years through five years.............. 229 237
Due after five years through ten years................ 1,259 1,304
Due after ten years................................... 3,067 3,151
------- -------
Totals.............................................. $13,149 $13,318
======= =======
There were no sales of investment securities held to maturity during the
years ended June 30, 1996, 1997, 1998 and for the six months ended December
31, 1998.
Accrued interest on investment securities held to maturity amounted to $408
and $189 as of June 30, 1998 and December 31, 1998, respectively.
At December 31, 1998, investment securities held to maturity with amortized
cost values of $1,401 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:
June 30, December 31,
1998 1998
-------- ------------
Land................................................. $ 4,483 $ 3,824
Buildings and building improvements.................. 10,453 12,213
Furniture, fixtures and equipment.................... 7,533 8,817
-------- -------
22,469 24,854
Less accumulated depreciation........................ 6,546 8,976
-------- -------
$ 15,923 $15,878
======== =======
(8) Deposits
Deposits consist of the following:
December 31,
June 30, 1998 1998
---------------- ----------------
Amount Percent Amount Percent
-------- ------- -------- -------
Demand deposits.......................... $ 25,811 8.2% $ 27,834 9.0%
NOW accounts............................. 36,679 11.7 40,275 13.0
Money market accounts.................... 34,635 11.0 32,781 10.6
Savings accounts......................... 65,764 20.9 60,001 19.5
Certificate accounts..................... 151,231 48.2 147,920 47.9
-------- ----- -------- -----
$314,120 100.0% $308,811 100.0%
======== ===== ======== =====
The combined weighted average interest rate of deposits was 4.02% and 3.77%
at June 30, 1998 and December 31, 1998, respectively. Accrued interest payable
on deposits was $148 and $74 at June 30, 1998 and December 31, 1998,
respectively.
F-15
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Interest expense, by category, is as follows:
Six Months
Year Ended June 30, Ended
--------------------- December 31,
1996 1997 1998 1998
------ ------ ------- ------------
NOW accounts............................ $ 404 $ 490 $ 557 $ 371
Money market accounts................... 1,489 1,603 1,808 1,237
Savings accounts........................ 300 307 346 387
Certificate accounts.................... 6,335 6,599 7,404 4,193
------ ------ ------- ------
$8,528 $8,999 $10,115 $6,188
====== ====== ======= ======
Scheduled maturities of certificate accounts at December 31, 1998 are as
follows:
Within one year................................ $ 141,461
Between one and two years...................... 4,313
Between two and three years.................... 540
Between three and four years................... 272
Between four and five years.................... 1,334
---------
$ 147,920
=========
Certificates of deposit issued in denominations in excess of $100,000
totaled $22,975 and $22,187 at June 30, 1998 and December 31, 1998.
(9) FHLB Advances and Stock
The Bank is required to maintain an investment in the stock of the Federal
Home Loan Bank of Seattle FHLB in an amount equal to at least 1% of the unpaid
principal balances of the Bank's residential mortgage loans or 5% of its
outstanding advances from the FHLB, whichever is greater. At December 31,
1998, the Bank was required to maintain an investment in the stock of FHLB of
Seattle of at least $1.4 million. Purchases and sales of stock are made
directly with the FHLB at par value.
A summary of FHLB Advances follows:
June 30, December 31,
1998 1998
-------- ------------
Balance at period end................................ $698 $687
Average balance...................................... 156 693
Maximum amount outstanding at any month end.......... 698 696
Average interest rate:
During the period.................................. 5.73% 6.20%
At period end...................................... 6.20% 6.20%
FHLB advances which have fixed interest rates are scheduled to mature as
follows:
June 30, December 31,
1998 1998
-------- ------------
Note payable, interest only payable monthly at
6.48%,
maturing on September 6, 2005...................... $328 $328
Note payable, in monthly installments including
interest at 5.95%, maturing on January 2, 2009..... 370 359
---- ----
$698 $687
==== ====
F-16
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Advances from the FHLB are collateralized by a blanket pledge on FHLB stock
owned by the Company, deposits at the FHLB and all mortgages or deeds of trust
securing such properties. In accordance with the pledge agreement, the Company
must maintain unencumbered collateral in an amount equal to varying
percentages ranging from 100% to 125% of outstanding advances depending on the
type of collateral.
The Bank may borrow from the FHLB in amounts up to 20% of its total assets.
(10) Other Borrowings
Other borrowings consist of the following:
June
30, December 31,
1998 1998
------- ------------
Securities sold under agreements to repurchase.......... $ 610 $--
Subordinated debentures................................. 500 --
Other................................................... 22 17
------- ----
$ 1,132 $ 17
======= ====
The maximum and average outstanding balances and average interest rates on
repurchase agreements were as follows:
Year Six Months
Ended Ended
June 30, December 31,
1998 1998
-------- ------------
Maximum outstanding at any month-end................... $610 $483
Average outstanding.................................... 21 320
Weighted average interest rate:
For the period....................................... 3.25% 3.25%
End of period........................................ 3.25% --
The subordinated debentures were repaid on December 31, 1998.
(11) Federal Income Taxes
Federal income tax expense (benefit) consists of the following:
Six Months
Year Ended June 30, Ended
-------------------- December 31,
1996 1997 1998 1998
------ ----- ------ ------------
Current................................... $1,173 $ 304 $1,980 $1,266
Deferred.................................. 262 (549) (17) (148)
------ ----- ------ ------
$1,435 $(245) $1,963 $1,118
====== ===== ====== ======
Federal income tax expense differs from that computed by applying the
Federal statutory income tax rate of 34% as follows:
Year Ended Six Months
June 30, Ended
---------------------- December 31,
1996 1997 1998 1998
------ ----- ------ ------------
Income tax expense at Federal
statutory rate....................... $1,431 $ 688 $1,901 $1,034
Reversal of provision for base year
bad debt reserve..................... -- (938) -- --
Other, net............................ 4 5 62 84
------ ----- ------ ------
$1,435 $(245) $1,963 $1,118
====== ===== ====== ======
F-17
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Heritage Bank has been permitted under the Internal Revenue Code to deduct
an annual addition to a reserve for bad debts in determining taxable income,
subject to certain limitations. The deduction was based on either specified
experience formulas or a percentage of taxable income before such deduction.
The Bank used the percentage of taxable income method for the years ended June
30, 1995 and 1996. This deduction was historically greater than the loan loss
provisions recorded for financial accounting purposes. Deferred income taxes
are provided on differences between the bad debt reserve for tax and financial
reporting purposes only to the extent of the tax reserves arising subsequent
to June 30, 1988. Savings institutions were not required to provide a deferred
tax liability for the tax bad debt reserves accumulated as of June 30, 1988
which for The Bank amounted to $938. Starting in the fiscal year ended June
30, 1994, The Bank established and maintained a deferred income tax liability
of $938 due to the potential recapture of the pre-1988 tax bad debt reserve
which could have been triggered by the formation of the mutual holding
company; a change to a commercial bank charter (which management had been
contemplating); or possible legislation which was being debated in Congress.
Legislation enacted in August 1996 eliminated certain conditions under which
recapture of the pre-1988 additions to the tax bad debt reserve would be
required. Such conditions are principally conversion to a commercial bank
charter or merger with a commercial bank. The pre-1988 reserves would be
required to be recaptured under certain other conditions such as payment of
dividends in excess of accumulated earnings and profits or other distributions
made in connection with the dissolution or liquidation of the Bank. Based on
this legislation, the Bank reversed the $938 deferred tax liability as a
reduction of Federal income tax expense during the year ended June 30, 1997.
The following table presents major components of the deferred Federal income
tax liability resulting from differences between financial reporting and tax
bases.
June 30, December 31,
1998 1998
-------- ------------
Deferred tax liabilities:
Deferred loan fees................................... $ 437 $ 363
Premises and equipment............................... 1,277 1,282
FHLB stock........................................... 399 425
Other................................................ 28 --
------ -------
Total deferred tax liabilities..................... $2,141 $ 2,070
====== =======
Deferred tax assets:
Loan loss allowances................................. $ (573) $ (682)
Management bonus..................................... (218) (178)
Vacation benefits.................................... (90) (108)
Charitable contributions............................. (36) (36)
Other................................................ (41) (31)
------ -------
Total deferred tax assets.......................... (958) (1,035)
------ -------
Deferred taxes payable, net........................ $1,183 $ 1,035
====== =======
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.
F-18
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(12) Stockholders' Equity
(a) Stock Offering and Conversion
Effective January 8, 1998, the Company sold 6.6 million shares of its common
stock at a subscription price of $10 per share to the Bank's customers, its
existing stockholders and the general public.
Of the 1.8 million shares of Heritage Savings Bank common stock outstanding
at December 31, 1997, 1.2 million shares owned by Heritage Financial
Corporation, M.H.C. (the "Mutual Holding Company") were canceled on January 8,
1998 and the Mutual Holding Company was merged into the Bank. The remaining
0.6 million shares of the Bank's common stock owned by its stockholders were
converted into 3.1 million shares of the Company's common stock outstanding.
Concurrent with the January 1998 stock conversion ("Conversion"), Heritage
Savings Bank established a liquidation account equal to $18.4 million which
represents the Mutual Holding Company's ownership interest in its Bank
subsidiary at June 30, 1997 plus the amount of dividends waived by the Mutual
Holding Company. The liquidation account is maintained for the benefit of
eligible depositors who maintain eligible accounts in the Bank after the
conversion. In the event of a complete liquidation of the Bank (and only in
such an event), eligible depositors who continue to maintain eligible accounts
shall be entitled to receive a distribution from the liquidation account
before any liquidating distribution may be made with respect to common stock.
(b) Earnings Per Common Share
The following table illustrates the reconciliation of weighted average
shares used for earnings per share computations:
Six Months
Year Ended June 30, Ended
----------------------------- December 31,
1996 1997 1998 1998
--------- --------- --------- ------------
Basic:
Weighted average shares........ 1,805,140 1,807,782 9,464,896 9,744,403
Effect of stock conversion..... 7,469,888 7,500,848 -- --
--------- --------- --------- ----------
Weighted average shares
outstanding................... 9,295,028 9,308,630 9,464,896 9,744,403
========= ========= ========= ==========
Diluted:
Basic weighted average shares
outstanding................... 9,295,028 9,308,630 9,464,896 9,744,403
Incremental shares from stock
options....................... 59,594 83,004 351,497 278,398
--------- --------- --------- ----------
Weighted average shares
outstanding................... 9,354,622 9,391,634 9,816,393 10,022,800
========= ========= ========= ==========
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.
At December 31, 1998, there were options to purchase 92,700 shares of common
stock outstanding which were antidilutive 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, 1997, and 1996.
F-19
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(c) Cash Dividend Declared
On December 18, 1998, the Company announced a quarterly cash dividend of 5
cents per share payable on January 25, 1999, payable to shareholders of record
on January 15, 1999.
(d) Restrictions on Dividends
Dividends from the Company depend, in part, upon receipt of dividends from
its subsidiary bank because the Company currently has no source of income
other than dividends from the 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 the Bank to the Company. For a period of ten years after the Conversion,
Heritage Bank may not, without prior approval of the DFI, declare or pay a
cash dividend in an amount in excess of one-half of (i) the greater of the
Bank's net income for the current fiscal year or (ii) the average of the
Bank's net income for the current fiscal year and not more than two of the
immediately preceding fiscal years. In addition, the 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.
(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. Each of the
Banks is a state chartered, federally insured institution and thereby subject
to the capital requirements established by the Federal Deposit Insurance
Corporation (FDIC). The Federal Reserve requirements generally parallel the
FDIC requirements. Failure to meet minimum capital requirements can initiate
certain mandatory, and possibly additional discretionary, actions by
regulators that, if undertaken, could have a direct material effect on the
Company's financial statements.
Pursuant to minimum capital requirements of the FDIC, the Bank is required
to maintain a leverage ratio (capital to assets ratio) of 3% and risk-based
capital ratios of Tier 1 capital and total capital (to total risk-weighted
assets) of 4% and 8%, respectively. At December 31, 1998, the Company and the
Bank exceeded the minimum capital requirements and the requirements for well
capitalized institutions as shown below. As of June 30, 1998 and December 31,
1998, the Banks (Heritage Bank and North Pacific Bank, where applicable) were
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)
Minimum Well-capitalized
Requirements Requirements Actual
---------------------------------------------
$ % $ % $ %
-------- --------------- -------------- -----
As of December 31, 1998:
The Company consolidated
Tier 1 leverage capital to
average assets............. $ 10,953 3% $ 18,255 5% $87,056 23.8%
Tier 1 capital to risk--
weighted assets............ 11,436 4% 17,154 6% 87,056 30.5%
Total capital to risk--
weighted assets............ 22,872 8% 28,589 10% 90,606 31.7%
Heritage Bank
Tier leverage capital to
average assets............. 10,305 3% 17,176 5% 74,652 21.7%
Tier 1 capital to risk--
weighted assets............ 11,337 4% 17,006 6% 74,652 26.3%
Total capital to risk--
weighted assets............ 22,674 8% 28,343 10% 78,195 27.6%
As of June 30, 1998:
The Company consolidated
Tier 1 leverage capital to
average assets............. 10,466 3% 17,443 5% 85,155 24.4%
Tier 1 capital to risk--
weighted assets............ 10,829 4% 16,243 6% 85,155 31.5%
Total capital to risk--
weighted assets............ 21,657 8% 27,072 10% 89,041 32.9%
Heritage Bank
Tier 1 leverage capital to
average assets............. 8,830 3% 14,717 5% 63,221 21.5%
Tier 1 capital to risk--
weighted assets............ 8,289 4% 12,434 6% 63,221 30.5%
Total capital to risk--
weighted assets............ 16,579 8% 20,723 10% 65,815 31.8%
North Pacific Bank
Tier 1 leverage capital to
average assets............. 2,383 3% 3,972 5% 8,967 11.3%
Tier 1 capital to risk--
weighted assets............ 2,438 4% 3,658 6% 8,967 14.7%
Total capital to risk--
weighted assets............ 4,877 8% 6,096 10% 10,137 16.6%
(14) Stock Option Plans
In September 1994, the Bank's stockholders approved the adoption of the 1994
stock option plan, providing for the award of a restricted stock award to a
key officer, incentive stock options to employees and nonqualified stock
options to directors of the Bank at the discretion of the Board of Directors.
On September 24, 1996, the Bank's stockholders approved the adoption of the
1997 stock option plan which is generally similar to the 1994 plan. On October
15, 1998, the Company's stockholders approved the adoption of the 1998 stock
option plan which is similar to the 1994 and 1997 plans. The 1998 plan does
not affect any options granted under the 1994 or 1997 plans.
Under these stock option plans, on the date of grant, the exercise price of
the option must at least equal the market value per share of the Bank's or
Company's common stock. The 1994 plan provides for the grant of 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.
F-21
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The following table summarizes stock option activity for the years ended
June 30, 1996, 1997, 1998 and the six months ended December 31, 1998. Option
activity for the periods prior to the stock offering January 8, 1998 has been
restated using the exchange ratio of one share of the Bank's common stock for
5.1492 shares of the Company's common stock.
Outstanding Exercisable
Options Options
---------------- ----------------
Avg. Avg.
Option Option
Shares Under Option Shares Price Shares Price
------------------- -------- ------ -------- ------
Balance at June 30, 1995..................... 231,713 $ 1.98 77,237 $1.98
Options granted.............................. 36,044 3.11 -- --
Became exercisable........................... -- -- 77,237 1.98
Less: Exercised.............................. (3,429) 1.94 (3,429) 1.94
-------- ------ -------- -----
Balance at June 30, 1996..................... 246,328 $ 2.14 151,046 $1.99
======== ====== ======== =====
Options granted.............................. 308,942 $ 3.58 -- $ --
Became exercisable........................... -- -- 88,207 2.14
Less: Exercised.............................. (20,339) 1.94 (20,339) 1.94
-------- ------ -------- -----
Balance at June 30, 1997..................... 552,931 $ 2.95 218,914 $2.05
======== ====== ======== =====
Options granted.............................. 9,000 $14.38 -- $ --
Became exercisable........................... -- -- 108,009 3.53
Less: Exercised.............................. (30,291) 2.32 (30,291) 2.32
Expired or canceled........................ (15,053) 3.58 -- --
-------- ------ -------- -----
Balance at June 30, 1998..................... 516,587 $ 3.17 296,632 $2.56
======== ====== ======== =====
Options granted.............................. 92,700 $11.13 -- $ --
Became exercisable........................... -- -- -- --
Less: Exercised.............................. (135,561) 2.29 (135,561) 2.27
Expired or canceled........................ (9,000) 14.38 -- --
-------- ------ -------- -----
Balance at December 31, 1998................. 464,726 $ 4.80 161,071 $2.80
======== ====== ======== =====
Under the 1997 plan, a restricted stock award of 3,000 shares with a fair
value of $43 was awarded to a key officer and required five years of
continuous employment from the date of award. These shares were issued during
June 1998. However, the officer left the Company's employment in December
1998, and therefore, the restricted stock award was rescinded.
Financial data pertaining to outstanding stock options at December 31, 1998
were as follows:
Weighted Average
Number of Option Remaining Contractual
Exercise Price Shares Life (in years)
-------------- ---------------- ---------------------
$ 1.94................................ 57,002 2.1
$ 2.33................................ 17,146 2.5
$ 3.11................................ 36,042 4.5
$ 3.58................................ 261,836 5.1
$11.13................................ 92,700 7.0
------- ---
464,726 5.0
======= ===
F-22
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
The Company has adopted the disclosure-only provisions of SFAS No. 123,
Accounting for Stock-based Compensation, but applies APB Opinion No. 25 and
related interpretations in accounting for its plans. Accordingly, no
compensation cost has been recognized for its stock option plans. If the
Company had elected to recognize compensation cost on the fair value at the
grant dates for awards under its plans, consistent with the method prescribed
by SFAS No. 123, net income and earnings per share would have been changed to
the pro forma amounts indicated below:
Six Months
Year Ended June 30 Ended
-------------------- December 31,
1996 1997 1998 1998
------ ------ ------ ------------
Net income:
As reported............................. $2,773 $2,269 $3,628 $1,924
Pro forma............................... 2,772 2,239 3,566 1,888
Earnings per common share:
Basic:
As reported............................. $0.30 $0.24 $0.38 $0.20
Pro forma............................... 0.30 0.24 0.38 0.19
Diluted:
As reported............................. $0.30 $0.24 $0.37 $0.19
Pro forma............................... 0.30 0.24 0.36 0.19
The compensation expense included in the pro forma net income is not likely
to be representative of the effect on reported net income for future years
because options vest over several years and additional awards generally are
made each year.
The fair value of options granted is estimated on the date of grant using
the minimum value method for grants in 1996 and 1997. The fair value of
options granted during the year ended June 30, 1998 and the six months ended
December 31, 1998 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:
Weighted
Risk Free Expected Expected Average
Interest Life (in Expected Dividend Fair
Grant period ended Rate years) Volatility Yield Value
------------------ --------- -------- ---------- -------- --------
June 30, 1996................ 6.50% 7 NA 3% $3.09
June 30, 1997................ 6.50% 7 NA 3% 3.19
June 30, 1998................ 6.00% 7 25% 1.3% 5.35
December 31, 1998............ 4.60% 7 25% 2.6% 4.82
(15) Employee Benefit Plans
The Company maintains 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 $192, $246,
$240, and $203 are included in the consolidated statements of income for the
years ended June 30, 1996, 1997, 1998 and six months ended December 31, 1998,
respectively.
The Company also maintains a 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
F-23
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
of age and with one year of service to the Company may participate in the
plan. Employees who participate may contribute a portion of their salary which
is matched by the employer at 50% up to certain specified limits. Employee
vesting in employer portions is similar to the retirement plan described
above. Employer contributions for the years ended June 30, 1996, 1997, 1998
and the six months ended December 31, 1998 were $82, $87, $104 and $69,
respectively.
(16) Employee Stock Ownership Plan and Trust
Heritage Bank established for eligible employees an employee stock ownership
plan (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. Heritage Bank contributed $75 to
the ESOP for the year ended June 30, 1997. Prior to the January 8, 1998 stock
offering, the ESOP owned the common stock of Heritage Bank with no related
debt.
In January 1998, the ESOP borrowed $1,323 from the Company to purchase
additional common stock of the Company. The loan will be repaid principally
from HB'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
and $65 for the year ended June 30, 1998 and the six months ended December 31,
1998, respectively.
As of December 31, 1998, the Company has allocated or committed to be
released to the ESOP 4,408 earned shares and has 124,169 unearned, restricted
shares remaining to be released. The fair value of unearned, restricted shares
held by the ESOP trust was $1,374 at December 31, 1998.
(17) 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 Bank.
(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.
F-24
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(c) Loans
For most loans, fair value is estimated using market prices for mortgage
backed securities with similar rates and average maturities adjusted for
servicing costs or calculated by discounting expected cash flows over the
estimated life of the loans using a current market rate reflecting the risk
associated with comparable loans. 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) Subordinated Debentures
The fair value of the subordinate debentures is estimated based on
discounting the estimated future cash flows using the rate currently offered
on similar borrowings with similar remaining maturities.
(g) Other Borrowings
Other borrowings consist of reverse repurchase agreements and a note payable
at no stated interest rate. Reverse repurchase agreements mature daily and are
valued the same as book value. The note payable fair value is based on
discounting the estimated future cash flows using the rate currently offered
on similar borrowings with similar remaining maturities.
(h) Off-Balance Sheet Financial Instruments
The fair value of off-balance sheet commitments to extend credit is
considered equal to its notional amount.
The table below presents the book value amount of the Bank's financial
instruments and their corresponding fair values:
June 30, 1998 December 31, 1998
----------------- -----------------
Book Fair Book Fair
value value value value
-------- -------- -------- --------
Financial Assets
----------------
Cash on hand and in banks.............. $ 12,065 $ 12,065 $ 10,369 $ 10,369
Interest bearing deposits.............. 50,542 50,542 36,355 36,355
Federal funds sold..................... 12,000 12,000 10,000 10,000
Investment securities available for
sale.................................. 9,041 9,041 25,792 25,792
Investment securities held to
maturity.............................. 29,731 29,975 13,149 13,318
FHLB stock............................. 1,985 1,985 2,062 2,062
Loans.................................. 272,224 277,205 285,193 289,944
Financial Liabilities
---------------------
Deposits:
Savings, money market and demand..... 162,889 162,889 160,891 160,891
Time certificates.................... 151,231 151,204 147,920 148,179
-------- -------- -------- --------
Total deposits..................... $314,120 $314,093 $308,811 $309,070
======== ======== ======== ========
FHLB advances.......................... $ 698 $ 714 $ 687 $ 719
Other borrowed funds................... $ 1,132 $ 1,134 $ 17 $ 16
F-25
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(18) 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.
(19) 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.
HERITAGE FINANCIAL CORPORATION
(PARENT COMPANY ONLY)
Condensed Statements of Financial Condition
June 30, December 31,
1998 1998
-------- ------------
ASSETS
------
Interest earning deposits................................. $ 12,280 $11,460
Loans receivable--ESOP.................................... 1,304 1,281
Investment in subsidiary banks............................ 80,895 83,025
Other assets.............................................. 111 230
-------- -------
$ 94,590 $95,996
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities............................................... $ 728 $ 569
Total stockholders' equity................................ 93,862 95,427
-------- -------
$ 94,590 $95,996
======== =======
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 Income
Year Six Months
Ended Ended
June 30, December 31,
1998 1998
-------- ------------
Interest income:
Interest bearing deposits........................... $ 737 $ 309
ESOP loan........................................... 54 55
Other income:
Equity in undistributed income of subsidiaries 3,273 2,134
------ ------
Total income...................................... 4,064 2,498
Other expenses........................................ 253 682
------ ------
Income before federal income taxes.................. 3,811 1,816
Provision for income taxes............................ 183 (108)
------ ------
Net income........................................ $3,628 $1,924
====== ======
Basic earnings per common share....................... $0.38 $0.20
Diluted earnings per common share..................... $0.37 $0.19
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
Year Six Months
ended Ended
June 30, December 31,
1998 1998
-------- ------------
Cash flows from operating activities:
Net income............................................. $ 3,628 $ 1,924
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Undistributed income of subsidiaries................. (3,273) (2,134)
Recognition of compensation related to ESOP.......... 54 55
Other................................................ (42) (1)
Net change in accrued interest receivable, prepaid
expenses
and other assets, and accrued expenses and other
liabilities......................................... 617 (347)
------- -------
Net cash provided by (used in) operations........ 984 (503)
Cash flows from investing activities:
ESOP loan net of principal repayments.................. (1,304) 23
Acquisition of wholly owned bank subsidiaries.......... (50,158) --
------- -------
Net cash provided by (used in) investing
activities...................................... (51,462) 23
Cash flows from financing activities:
Cash dividends paid.................................... (342) (826)
Issuance of restricted stock award and exercise of
stock options......................................... 70 486
Net proceeds from stock offering....................... 63,758 --
------- -------
Net cash provided by financing activities........ 62,758 (340)
------- -------
Net increase (decrease) in cash and cash
equivalents..................................... 12,280 (820)
Cash and cash equivalents at beginning of period......... -- 12,280
------- -------
Cash and cash equivalents at end of period............... $12,280 $11,460
======= =======
F-28
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
(20) Selected Quarterly Financial Data (Unaudited)
Results of operations on a quarterly basis were as follows (dollars in
thousands, except for per share amounts):
Six Months
Ended
December 31,
1998
---------------
First Second
Quarter Quarter
------- -------
Interest income........................................... $7,816 $7,830
Interest expense.......................................... 3,144 3,090
------ ------
Net interest income..................................... 4,672 4,740
Provision for loan losses................................. 90 90
------ ------
Net interest income after provision for loan losses..... 4,582 4,650
Non-interest income....................................... 1,140 1,299
Non-interest expense...................................... 3,723 4,906
------ ------
Income before provision for income taxes................ 1,999 1,043
Provision for income taxes................................ 722 396
------ ------
Net income............................................ $1,277 $ 647
====== ======
Basic earnings per share.................................. $.13 $.07
Diluted earnings per share................................ $.13 $.06
Cash dividends declared................................... $.045 $.05
Year ended June 30, 1998
-------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
Interest income................................ $5,050 $5,380 $6,122 $6,589
Interest expense............................... 2,405 2,571 2,510 2,642
------ ------ ------ ------
Net interest income.......................... 2,645 2,809 3,612 3,947
Provision for loan losses...................... 30 30 30 30
------ ------ ------ ------
Net interest income after provision for loan
losses...................................... 2,615 2,779 3,582 3,917
Non-interest income............................ 893 880 1,047 971
Non-interest expense........................... 2,563 2,657 2,849 3,024
------ ------ ------ ------
Income before provision for income taxes..... 945 1,002 1,780 1,864
Provision for income taxes..................... 335 356 621 651
------ ------ ------ ------
Net income................................. $ 610 $ 646 $1,159 $1,213
====== ====== ====== ======
Basic earnings per share....................... $0.06 $0.07 $0.12 $0.13
Diluted earnings per share..................... $0.06 $0.07 $0.12 $0.12
Cash dividends declared........................ $-- $-- $0.035 $0.04
F-29
HERITAGE FINANCIAL CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Dollars in thousands)
Year ended June 30, 1997
--------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
------- ------- ------- -------
Interest income................................ $4,459 $4,591 $4,592 $4,870
Interest expense............................... 2,246 2,270 2,199 2,285
------ ------ ------ ------
Net interest income.......................... 2,213 2,321 2,393 2,585
Provision for loan losses...................... -- -- -- (270)
------ ------ ------ ------
Net interest income after provision for loan
losses...................................... 2,213 2,321 2,393 2,855
Non-interest income............................ 866 846 726 909
Non-interest expense........................... 3,414 2,389 2,400 2,902
------ ------ ------ ------
Income before provision for income taxes..... (335) 778 719 862
Provision for income taxes..................... (1,051) 266 245 295
------ ------ ------ ------
Net income................................. $ 716 $ 512 $ 474 $ 567
====== ====== ====== ======
Basic earnings per share....................... $0.08 $0.05 $0.05 $0.06
Diluted earnings per share..................... $0.08 $0.05 $0.05 $0.06
Cash dividends declared........................ NM NM NM NM
Cash dividends prior to January 1998 stock offering and conversion are not
comparable to prior periods due to the former mutual holding company's waiver
of its pro rata cash dividends.
F-30
EXHIBIT INDEX
Exhibit
No. Description
------- -----------
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 as of October 1, 1997.(1)
Severance Agreement between the Company and Brian L. Vance, effective
10.3 October 1, 1997.(1)
Severance Agreement between the Company and John D. Parry, effective
10.4 October 1, 1997.(1)
10.5 Form of Severance Agreement entered into between the Company and seven
additional executives, effective as of October 1, 1997.(1)
10.6 1997 Stock Option and Restricted Stock Award Plan(3)
21.0 Subsidiaries of the Company
23.0 Consent of KPMG LLP
24.0 Power of Attorney dated February 25, 1999
27.0 1998 Financial Data Schedule
- --------
(1) Incorporated by reference to the Registration Statement on Form S-1 (Reg.
No. 333-35573) declared effective on November 12, 1997.
(2) Incorporated by reference to the definitive Proxy Statement dated
September 14, 1998 for the Annual Meeting of Shareholders to be held on
October 15, 1998.
(3) Incorporated by reference to the Registration Statement on Form S-8 (Reg.
No. 333-57513).