Heritage Financial Announces Third Quarter Results And Declares Cash Dividend

Mr. Vance commented, "Our results this year continue to improve over last year's results with the current quarter net income up 56% over last year's third quarter and up 139% year to date over the same period last year.  Our earnings were down two cents per share on a linked quarter basis primarily due to a lower margin, an increased provision on our purchased loans and the change in our FDIC indemnification asset.  As we have stated before, the extended period of extraordinarily low interest rates is going to continue to put pressure on our margin.  A bright spot in this quarter versus this year's second quarter is our lower noninterest expense in spite of incurring approximately $180,000 in merger-related expenses associated with our pending acquisition of Northwest Commercial Bank."

Balance Sheet

The Company's total assets increased to $1.37 billion at September 30, 2012 from $1.34 billion at June 30, 2012.  During the quarter ended September 30, 2012, cash and cash equivalents increased by $33.6 million to $116.9 million, which was a result of increases in total deposits and securities sold under agreement to repurchase. 

Total originated loans (not including loans held for sale) increased $18.3 million to $872.0 million at September 30, 2012 from $853.6 million at June 30, 2012.  The increase was due significantly to a $12.5 million increase in commercial business loans and a $4.9 million increase in real estate construction and land development loans during the quarter.

Total deposits increased to $1.13 billion at September 30, 2012 from $1.11 billion at June 30, 2012.  Total non-maturity deposits increased $32.2 million to $838.6 million at September 30, 2012 from $806.4 million at June 30, 2012 while certificates of deposit decreased $11.9 million to $295.1 million at September 30, 2012 from $307.0 million at June 30, 2012.  Non-maturity deposits to total deposits increased to 74.0% at September 30, 2012 from 72.4% at June 30, 2012.  In addition, noninterest demand deposits to total deposits increased to 22.0% at September 30, 2012 from 20.5% at June 30, 2012. 

Total equity increased $2.1 million to $202.2 million at September 30, 2012 from $200.1 million at June 30, 2012.  The increase was due to $2.9 million in net income partially offset by $1.2 million in cash dividends declared.  During the quarter ended September 30, 2012, the Company did not repurchase any shares.  For the nine months ended September 30, 2012, the Company has repurchased 392,000 shares at a weighted average price of $13.44.  The Company and its subsidiary banks continue to maintain capital levels significantly in excess of the applicable regulatory requirements for them to be categorized as "well-capitalized". The Company had Tier 1 leverage, Tier 1 risk-based and total risk-based capital ratios at September 30, 2012 of 14.0%, 19.1% and 20.4%, respectively, as compared to 13.8%, 18.9% and 20.2% at June 30, 2012, respectively. 

Mr. Vance continued, "We are pleased to again see loan growth in our originated portfolio following loan growth in the second quarter.  The loan growth this quarter more than offset the reductions in the purchased loan portfolio.  In spite of increased new business we remain cautious about our loan growth continuing at its current pace."

Credit Quality

The allowance for loan losses on originated loans at September 30, 2012 decreased $310,000 to $20.5 million from $20.8 million at June 30, 2012 as a result of $525,000 of net charge-offs recognized during the quarter.  Nonperforming originated loans to total originated loans was 1.57% at September 30, 2012, a decrease from 1.69% at June 30, 2012.  Nonaccrual originated loans decreased $1.0 million to $15.7 million ($13.7 million net of government agency guarantees) at September 30, 2012 from $16.7 million at June 30, 2012.  The decrease in nonaccrual loans was due to a combination of principal reductions, charge-offs and transfers to other real estate owned. 

The allowance for loan losses to nonperforming originated loans was 149.9% at September 30, 2012 compared to 144.7% at June 30, 2012.  Potential problem originated loans were $29.4 million at September 30, 2012 compared to $28.3 million at June 30, 2012. Restructured originated performing loans were $15.3 million at September 30, 2012 compared to $14.1 million at June 30, 2012.  The Company believes that its allowance for loan losses is appropriate to provide for probable incurred losses based on an evaluation of known and inherent risks in the loan portfolio at September 30, 2012.

Nonperforming originated assets were $22.7 million ($20.7 million net of government agency guarantees), or 1.72% of total originated assets, at September 30, 2012, compared to $24.8 million ($22.5 million net of government agency guarantees), or 1.92% of total originated assets, at June 30, 2012.  Other real estate owned decreased to $7.3 million at September 30, 2012 (of which $260,000 was covered by Federal Deposit Insurance Corporation ("FDIC") loss sharing agreements) from $8.6 million at June 30, 2012 (of which $563,000 was covered by FDIC loss sharing agreements).  The decrease in other real estate owned was due to the disposition of 11 properties totaling $1.8 million partially offset by the addition of two properties totaling $453,000.  During the quarter ended September 30, 2012, the Company recognized a net gain of $2,000 on the disposition of the 11 properties.

Mr. Vance added, "We are especially pleased to report overall credit metrics on our originated loan portfolio continue to improve.  Nonperforming originated loans are down to 1.57% of originated loans and the allowance for loan losses to nonperforming originated loans increased to 149.9%.  Nonperforming originated assets decreased 8.3% during the quarter ended September 30, 2012 and are down to 1.72% of total originated assets. In addition, other real estate owned decreased $1.3 million, or 15.6%, during the quarter ended September 30, 2012.  We are optimistic that we will continue to see improving credit metrics trends."

Operating Results

Net interest income decreased $1.3 million, or 7.8%, to $16.0 million for the quarter ended September 30, 2012 compared to $17.3 million for the same period in 2011.  Net interest income decreased $2.2 million, or 4.3%, to $48.9 million for the nine months ended September 30, 2012 compared to $51.1 million during the same period in the prior year.  The decrease in net interest income is due to the decline in net interest margins during the respective periods.

Heritage's net interest margin for the quarter ended September 30, 2012 decreased to 5.10% from 5.47% for the same period in 2011 and from 5.25% in the linked-quarter ended June 30, 2012.  The net interest margin for the nine months ended September 30, 2012 decreased to 5.23% from 5.49% in the same period in 2011.  The decline in net interest margin is due to a combination of lower contractual note rates and the lessening impact of discount accretion on the acquired loan portfolios.

The effect on the net interest margin of discount accretion on the acquired loan portfolios for the quarter ended September 30, 2012 was approximately 49 basis points compared to 72 basis points in the same quarter of the prior year and 55 basis points for the linked quarter ended June 30, 2012.  Interest reversals on nonaccrual originated loans impacting the net interest margin for the quarter ended September 30, 2012 were approximately six basis points compared to 11 basis points for the same quarter in the prior year and eight basis points for the linked quarter ended June 30, 2012.

The provision for loan losses on originated loans decreased to $215,000 for the quarter ended September 30, 2012 compared to $395,000 for the quarter ended September 30, 2011.  For the nine months ended September 30, 2012, the provision for loan losses on originated loans decreased to $415,000 from $5.0 million for the nine months ended September 30, 2011.  The decrease in provision expense was substantially due to improving credit quality metrics, such as the decrease in ratio of nonperforming originated loans to total originated loans as noted above. The Company had net charge-offs of $525,000 for the quarter ended September 30, 2012 compared to net charge-offs of $1.9 million for the quarter ended June 30, 2012 and net charge-offs of $19,000 for the quarter ended September 30, 2011.  For the nine months ended September 30, 2012, the Company had net charge-offs of $2.2 million compared to $3.3 million for the nine months ended September 30, 2011.

The provision for loan losses on purchased loans totaled $592,000 for the quarter ended September 30, 2012 compared to $2.8 million for the comparable period in the prior year and $419,000 for the linked quarter ended June 30, 2012.  For the nine months ended September 30, 2012, the provision for loan losses on purchased loans was $902,000 compared to $6.1 million for the nine months ended September 30, 2011. As of the acquisition dates, purchased loans were recorded at their estimated fair value, incorporating our estimate of future expected cash flows until the ultimate resolution of these credits.  To the extent actual or projected cash flows are less than previously estimated, additional provisions for loan losses on the purchased loan portfolios will be recognized immediately into earnings.  To the extent actual or projected cash flows are more than previously estimated, the increase in cash flows is recognized immediately as a recapture of provision for loan losses up to the amount of any provision previously recognized for that pool of loans, if any, then prospectively recognized in interest income as a yield adjustment.

Cash flows on pools of acquired loans are re-estimated on a quarterly basis. As reflected in the table below, incremental accretion income was $1.6 million for the quarter ended September 30, 2012 compared to $1.7 million for the quarter ended June 30, 2012 and $2.3 million for the quarter ended September 30, 2011.  For the nine months ended September 30, 2012, incremental accretion income was $4.8 million compared to $6.5 million for the nine months ended September 30, 2011.

For the quarter ended September 30, 2012, the Company recognized $(492,000) of change in the FDIC indemnification asset compared to $(19,000) and $(1.7) million for the quarters ended June 30, 2012 and September 30, 2011, respectively.  For the nine months ended September 30, 2012, the Company recognized $(687,000) of change in the FDIC indemnification asset compared to $(2.6) million for the nine months ended September 30, 2011.

The following table illustrates the significant accounting entries associated with the Company's acquired loan portfolios:

Donald J. Hinson, Executive Vice President and Chief Financial Officer, commented, "As we have expected, we are continuing to experience a declining net interest margin.  The effects of the discount accretion on the net interest margin are lessening as acquired loan balances decline.  In addition, contractual note rates on the loan portfolio and yields on the investment portfolio are decreasing more rapidly than our cost of funds. This trend is expected to continue while we are in a low rate environment."

Noninterest income was $1.5 million for the quarter ended September 30, 2012 compared to $239,000 for the same period in 2011 and $2.1 million for the linked-quarter ended June 30, 2012. For the nine months ended September 30, 2012, noninterest income increased $2.1 million to $5.5 million from $3.4 million for the nine months ended September 30, 2011.

The increases in noninterest income are primarily due to the change in the FDIC indemnification asset.  Merchant Visa income and merchant Visa expense are now reported net in noninterest income (merchant Visa expense was previously reported as noninterest expense).  For comparability purposes, prior year amounts have also been netted.

Noninterest expense was $12.5 million for the quarter ended September 30, 2012 compared to $11.8 million for the quarter ended September 30, 2011 and $12.9 million for the linked-quarter ended June 30, 2012. The increase for the three months ended September 30, 2012 compared to the same period in the prior year was due to increased salaries and employee benefits expense of $729,000 and increased professional services expense of $225,000.  The increase in salaries and benefits expense was due primarily to increased incentive compensation as well as new deferred compensation arrangements. The increase in professional services is substantially due to costs incurred during the quarter ended September 30, 2012 relating to the proposed acquisition of Northwest Commercial Bank.  The acquisition is expected to close during the quarter ending December 31, 2012 subject to regulatory approval and the approval of Northwest Commercial Bank's shareholders. Noninterest expense increased $530,000, or 1.4%, to $38.0 million for the nine months ended September 30, 2012 compared to $37.4 million for the nine months ended September 30, 2011.

Dividend

On October 30, 2012, the Company's Board of Directors declared a quarterly cash dividend of $0.08 per common share payable on November 21, 2012 to shareholders of record on November 9, 2012. 

Earnings Conference Call

The Company will hold a telephone conference call to discuss this earnings release on October 31, 2012, at 11:00 a.m. Pacific time.  To access the call, please dial (800) 230-1059 a few minutes prior to 11:00 a.m. Pacific time.  The call will be available for replay through November 14, 2012, by dialing (800) 475-6701 -- access code 266044.

About Heritage Financial

Heritage Financial Corporation is a bank holding company headquartered in Olympia, Washington.  The Company operates two community banks, Heritage Bank and Central Valley Bank.  Heritage Bank serves western Washington and the greater Portland, Oregon area through its twenty-seven full-service banking offices and its Online Banking Website www.HeritageBankNW.com.  Central Valley Bank serves Yakima and Kittitas counties in central Washington through its six full-service banking offices and its Online Banking Website www.CVBankWA.com.  Additional information about Heritage Financial Corporation is available on its Internet Website www.HF-WA.com.

Non-GAAP Financial Measures

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

Forward-Looking Statements

"Safe Harbor" statement under the Private Securities Litigation Reform Act of 1995: This release contains forward-looking statements that are subject to risks and uncertainties, including, but not limited to: the credit risks of lending activities, including changes in the level and trend of loan delinquencies and write-offs and changes in our allowance for loan losses and provision for loan losses that may be impacted by deterioration in the housing and commercial real estate markets; changes in general economic conditions, either nationally or in our market areas; changes in the levels of general interest rates, and the relative differences between short and long term interest rates, deposit interest rates, our net interest margin and funding sources; fluctuations in the demand for loans, the number of unsold homes and other properties and fluctuations in real estate values in our market areas; results of examinations of us by the Board of Governors of the Federal Reserve System and of our bank subsidiaries by the Federal Deposit Insurance Corporation, the Washington State Department of Financial Institutions, Division of Banks or other regulatory authorities, including the possibility that any such regulatory authority may, among other things, require us to increase our allowance for loan losses, write-down assets, change our regulatory capital position or affect our ability to borrow funds or maintain or increase deposits, or impose additional requirements and restrictions on us, any of which could adversely affect our liquidity and earnings; legislative or regulatory changes that adversely affect our business including changes in regulatory policies and principles, including the interpretation of regulatory capital or other rules including changes related to Basel III; the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act and the implementing regulations ; our ability to control operating costs and expenses; the use of estimates in determining fair value of certain of our assets, which estimates may prove to be incorrect and result in significant declines in valuation; difficulties in reducing risk associated with the loans on our balance sheet; staffing fluctuations in response to product demand or the implementation of corporate strategies that affect our workforce and potential associated charges; computer systems on which we depend could fail or experience a security breach; our ability to retain key members of our senior management team; costs and effects of litigation, including settlements and judgments; our ability to implement our expansion strategy; our ability to successfully integrate any assets, liabilities, customers, systems, and management personnel we have acquired including the Cowlitz Bank and Pierce Commercial Bank transactions, or may in the future acquire into our operations, including the proposed acquisition of Northwest Commercial Bank and our ability to realize related revenue synergies and cost savings within expected time frames and any goodwill charges related thereto; risks relating to acquiring assets or entering markets in which we have not previously operated and may not be familiar; changes in consumer spending, borrowing and savings habits; the availability of resources to address changes in laws, rules, or regulations or to respond to regulatory actions; adverse changes in the securities markets; inability of key third-party providers to perform their obligations to us; changes in accounting policies and practices, as may be adopted by the financial institution regulatory agencies or the Financial Accounting Standards Board, including additional guidance and interpretation on accounting issues and details of the implementation of new accounting methods; other economic, competitive, governmental, regulatory, and technological factors affecting our operations, pricing, products and services; and other risks detailed from time to time in our filings with the Securities and Exchange Commission.

The Company cautions readers not to place undue reliance on any forward-looking statements. Moreover, you should treat these statements as speaking only as of the date they are made and based only on information then actually known to the Company. The Company does not undertake and specifically disclaims any obligation to revise any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. These risks could cause our actual results for future periods to differ materially from those expressed in any forward-looking statements by, or on behalf of, us, and could negatively affect the Company's operating and stock price performance.

SOURCE HERITAGE FINANCIAL CORPORATION

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